ECO509 - Business Conditions Analysis

Notes on Chapter 9 - Economic Fluctuations

2009-03-10T16:47:00.016-05:00

Introduction

In the long run, the economy, measured by GDP, is constantly growing. You can see the long-term GDP growth trend in the graph of US GDP from 1947 through the end of 2008.

However, if you look at the graph carefully, you'll see that there are short-term periods in which the economy grows at a slower pace, stays level or even contracts. These periods of falling real national income are known as recessions. Eventually, the economy recovers and continues on its growth path.

Short-run fluctuations in output and employment are often correlated and known as the business cycle.

In our study of economic fluctuations, we seek to:

1. Obtain a more complete understanding of the data, primarily GDP and unemployment rate, that are used to measure the economy and describe the short-run fluctuations.

2. Understand differences between short-run and long-run economic behavior.

3. Develop a model which can be used to describe and predict economic behavior in the short-run. We will call this model the AD-AS model and base it on the concepts of aggregate demand and aggregate supply which will be developed in our analysis.

Our ultimate goal is to understand the economic variables well enough to control the cycle of economic fluctuations through effective fiscal and monetary policies. We're not trying to eliminate the cycle entirely. That would likely be impossible. Rather, we are attempting to minimize the severity of the peaks and troughs in the cycle.

GDP, Unemployment and Okun's Law

Some notes on GDP:
Average annual GDP growth in the US is 3.5%.
Officially, the NBER Business Cycle Dating Committee determines when recessions begin and end.
NBER's rule of thumb is that a recession is defined as two consecutive quarters of declining real GDP. This is a rule of thumb and not a strict definition. Other economic factors are taken into account in the final analysis.

Note: It's unclear to me whether the rule of thumb is defined by declining growth in GDP or by negative growth in GDP. I.e. is it enough for the growth to be slowing down, or does the growth rate have to actually be less then zero?
Another interesting question is whether we compare GDP growth from quarter to quarter or from one quarter to the same quarter 4 quarters ago. The later method would take into account seasonal changes to some degree.

GDP = Y = C + I + G + NX

So we might expect all the components of GDP to decline during a recession. That is the case for consumption (C) and investment (I). However, we find that recessions have a more dramatic impact on investment (I = equipment, structures, housing, inventories, etc) than on household consumption (C).

Some notes on unemployment:
During recessions, unemployment generally increases. Economic growth slows when more workers are unemployed. The unemployment rate is related to the decline in GDP by Okun's Law:

%ΔGDP = 3.5% - 2 x Δ%Unemployment

This formula essentially means that the economy, measured by GDP, will grow by 3.5% when the unemployment rate is stable. If unemployment increases, GDP will drop by 2% for every 1% that unemployment increases, and vice versa.

Edward S. Knotek, an economist at the Federal Reserve Bank of Kansas City, has written an interesting article entitled How Useful is Okun's Law?

Notes on Chapter 14 - Stabilization Policy

2008-11-28T12:50:00.013-06:00

Chapter 14 - Stabilization Policy

We learned about the business cycle in Chapter 9. We also learned about shocks to the economy, both demand shocks which shift the aggregate demand curve and supply shocks which shift the aggregate supply curve. We also discussed ways in which policymakers can react to these shocks in order to dampen their effects and return the economy to natural levels.

In this chapter, we discuss stabilization policy in more detail to answer some fundamental questions about how government policymakers should respond to the business cycle:

Should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive?
Should policymakers be free to use their discretion in responding to changing economic conditions, or should they be committed to following a fixed policy rule?

Should Policy Be Active or Passive?

Monetary and fiscal policy have a significant impact on aggregate demand, inflation and unemployment. Use of monetary and fiscal policy to stabilize the economy is relatively recent, beginning with the Employment Act of 1946. Economists differ in their opinions as to whether government should actively use policy to stabilize the economy or whether they should take a hands-off approach.

There are three major criticisms of active government intervention in using monetary and fiscal policy to stabilize the economy:

Lags in the Implementation and Effect of Policy
Difficulty in Economic Forecasting
Lucas Critique

Policy Implementation and Effect Lags. Implementation lag, also called inside lag, occurs when there is a lag in time between the economic shock and the implementation of policy. This lag occurs because it takes some time for economists to recognize the shock and for government to implement the policy. Policy effect lag, also called outside lag, occurs when there is a lag in time between the implementation of a policy and the effect that it has on the economy. Both inside and outside lag can be long and variable in length.

Fiscal policy suffers from a long inside lag because it takes a significant amount of time for Congress to pass legislation that affects taxes or government spending. Mankiw recently posted an article that noted that changes in fiscal policy, specifically through government spending, also suffer from an inside lag between the time the policy is passed by Congress and when it is implemented by the funds becoming available.

Although the central bank can adjust its policies quickly, monetary policy suffers from a long outside lag. Changes to money supply and interest rates influence investment and aggregate demand. Since many investment decisions are planned in advance, changes to monetary policy generally have a lag of about 6 months before their effect is felt in the general economy.

Automatic stabilizers are policies which stabilize the economy automatically without any changes to monetary or fiscal policy. Examples of automatic stabilizers are taxes and transfer payments. Taxes increase when the economy grows and income increases, thus having a dampening effect on the growing economy. Transfer payments increase as unemployment increases and income falls, thereby having a stimulating effect on the economy.

Economic Forecasting is Difficult
Because of the outside lags noted above, setting economic policy requires governments and central banks to forecast economic conditions six months in the future or more. Economists use both leading indicators and economic models to forecast economic conditions.

By their nature, economic models are limited in their ability to predict the future. In this respect, they are similar to the models that weather forecasters use to predict the weather and are often inaccurate. Two examples are the Great Depression of the 1930s and the recession of 1982.

The Lucas Critique
Robert Lucas is a Nobel Prize-winning economist who is currently associated with the University of Chicago. Lucas developed a theory, known as the Lucas Critique, which posits that the economy is influenced by people's expectations and those expectations are influenced by economic policy. Therefore, the very act of changing economic policy may influence the economy to more or less of a degree than anticipated by economic models due to the effect of the policy change on the public's expectations. In order to account for these effects, economic models should be modified to account for the influence of policy on expectations and economic activity.

The History of Stabilization Policy
In trying to determine whether stabilization policy should be active or passive, you would think that we could look back at history and see whether active or passive policy has been more successful. A few reasons are given why historical review doesn't give us a definitive answer.

1. When examining policy failures, i.e. large shocks, it's not always clear which policy would have been better. For example, concerning the Great Depression, some economists believe that a more active policy would have been the best way to address the situation. Other economists believe that a passive policy may have avoided the Great Depression in the first place.

2. Some economists look at the long term economic data and note that the economic shocks after the 1930s, when Keynes's theory was published and governments started instituting active policy, have been much less severe than the shocks prior to that time. This would seem to point in favor of active stabilization policy. However, Christina Romer, a UC-Berkeley professor and currently nominated for Chair of the Council of Economic Advisors, has noted that since the 1930s we have been gathering more and better economic data. Therefore, it may just be that we have better data in recent years, not that the active policy has made the shocks less severe.

Recent Stability
Throughout the 1990s and 2000s the GDP growth and inflation have been relatively less volatile than in prior years. Mankiw attributes this stability to 3 factors:
1. The US economy is now more service-based which is more stable.
2. Shocks just happen to have been less severe.
3. Fed Chairman Greenspan's management of interest rates and money supply stabilized the economy.

Economics Think Tanks

2008-06-15T13:48:00.003-05:00

Some of the institutions that I came across during my research for our group project for ECO 509:
OECD
Organisation for Economic Co-operation and Development.
www.oecd.org

NBER
Cato Institute
Economic Policy Institute
Hoover Institution
Brookings Institution
Urban Institute

A really big list of econ resources from 1999 that should be updated.

Prominent Contemporary US Economists

2008-06-15T10:09:00.003-05:00

I'm very interested in the history of science, both natural sciences and social sciences. I also consider understand important current events an integral part of understanding history as it unfolds. Therefore, now that the official course is over, I'll take some time on this blog to learn about contemporary economists, their backgrounds and their approaches.

I heard so many economists' names mentioned during the class and I constantly see more in the news on a daily basis. I rarely know who's a supply-sider, who's from the "Chicago School" or who's involved with a liberal think tank. So I'll try to categorize the biographies without, hopefully, unfairly pigeon-holing anyone.

I'm including:
Policymakers
Academic economists
Major banking officials

I'm not sure of the best way to structure these entries, so I'll just start jotting things down and hope I can make sense of them in the end.

Board Governors of Federal Reserve System
Ben S. Bernanke (chairman)
Donald L. Kohn (vice chairman)
Kevin M. Warsh
Randall S. Kroszner
Frederic S. Mishkin

There are two vacant positions on the board. President Bush nominated Elizabeth Duke and Larry Klane to fill those positions in 2007, but the Senate has not held confirmation hearings to confirm them.

Randall S. Kroszner's term expired on January 31st, 2008, but he continues to serve on the Board until he is either reconfirmed or a successor is named.

Frederic S. Mishkin recently (May 28th, 2008?) resigned his position, effective August 31st, 2008. Related articles:
MarketWatch
TheBulletin

The Final Exam

2008-06-15T10:07:00.001-05:00

Yipes!

I'll comment on the final exam after it's graded, grades are posted and I have a chance to review it with Professor Woo.

Lecture 10 - Learning from Japan

2008-06-04T19:21:00.002-05:00

See packet page 8

Key Questions
1. Is it possible to recognize when an economy is moving to a phase of sustained deflation?

Japan had bad forecasting. (See graph on packet page 7) Monetary policy is usually based on forecasts. Therefore, their monetary policy was too tight.

Use the Taylor Rule, developed by John B Taylor, (see page 16 and graph on pg 17). Greenspan is criticized for keeping the interest rates below the taylor rule during 2004-6.

More factors depressing AD further (need this slide)

Bursting of the asset price bubble
Weakened banking system
Deflationary expectation: as people anticipate the deflation to continue, tehy postpone their...

Was the Fiscal Policy Stance Appropriate?
See packet page 10
Tax cuts vs. spending increase
Temporary vs permanent

Fiscal packages depend heavily on public works programs (G up) (such as Kansai airport) and temporary income tax cuts (such as 5.9 trillion yen income tax rebate in FY 1994)

It seems that this heavy reliance on public works programs is politically driven (political connection of construction companies). See "bridge to nowhere". Many projects such as bridges and roads in remote areas failed to lead to second-, third-round private spending increase.

Temporary income tax... (see rest of slide in packet)

Fiscal packages depend heavily

Lecture 10 - AD-AS Model

2008-06-04T17:47:00.004-05:00

Final Exam Prep

Final starts from the "Money and Inflation" lecture.

The final will be predominantly multiple choice, less analysis.

Boom Cycle

See AD-AS Diagram on page 12 of packet.

How does a stock/housing boom cycle work?

Initially, we're at equilibrium (point 1). When a boom occurs, C and I go up, leading to a rightward/upward shift in AD. In the short run, you end up at point 2 and you have an inflationary gap. We have close to full employment (or at least the lower theoretical unemployment, considering that some ppl are always out of work).

At point 2, Y is greater than Ybar (expected output). There may even be unemployment less than the "natural" minimum, U^N. The labor market tightens and labor demand goes up, leading to upward pressures on wages (which are 70% of cost of production), leading to increased cost of production.

Over time, more and more firms raise their prices and the SRAS curve shifts upward. And we end up at equilibrium point 3: output is lower and prices are higher. But there still may be an inflationary gap. The SRAS curve should continue moving upward until it eliminates the gap at point 5 (where did point 4 go?).

At this point you're at full employment level. No extra workers. In the absent of any monetary of fiscal policy intervention, you just end up with higher prices and no other changes. :( This is the wage and price spiral. Policy tries to push the AD curve down buy other mechanisms.

This is illustrated in the diagram on page 14 of the packet.

Recession Cycle

Take the case of Japan: 1992-

They had full level of employment in the 1990s. Before 1990, there was an asset price bubble. At the height of the bubble, a commonly-quoted claim was that the land beneath the Imperial Palace in Tokyo was worth more than the entire state of California.Between 1990 and 1992, there was a massive asset price collapse. The Nikkei 225 (like S&P 500) dropped from almost 40,000 to 20,000.

(i) Balance-sheet channel. This led to bankruptcies of households and firms. There was no longer appetite for consumption or investment. C down, I down.
(ii) Bank-lending channel. Led to loan losses, banks went bankrupt and were acquired by the government. They were nationalized. Credit to households and firms were severely reduced. It became very difficult to borrow from banks. Consumption and investment (C and I) both went down.
(iii) Deflationary effects. If prices are going down, people will postpone purchases, thereby pushing down consumption and investment. (C and I down).

Due to all these channels, the AD went down, creating a recessionary gap. Deflation doesn't necessary result in lower prices, but it could be that prices are growing less quickly.

This results in U greater than U^N and then downward pressure on wages, lower cost of production. SRAS curve shifts downward and over time, lower prices. A new equilibrium at point 3, yet still Y is less than Ybar until over time, firms cut prices and SRAS meets LRAS and AD. Eventually, the economy returns to potential GDP, yet prices are now permanently lower.

The Japenese tried to push the AD back up through policy, but it didn't work. Bernanke is trying to do that now in the US also.

Supply shocks

A supply shock to aggregate supply is a shock to the economy that alters the cost of production and as a result the prices that firms charge.

(1) Positive supply shock (would shift SRAS to the right)
Ex: Productivity gains from new technology such as IT revolution.

(2) Negative supply shock (would shift SRAS to the left)
Examples:
Drought that destroy crops
New environmental protection law
Labor strike, increased wages
Oil price shocks

Consider adverse supply shocks (ex: oil price shock) - SRAS curve shifts upward. The result is higher prices and lower output (P up, Y down). This is called stagflation.

Fed options:
(i) Do nothing. Go through the recession until prices return to P1 and Y returns to Ybar.
(ii) Push the AD outward with monetary expansion. But this comes at the cost of higher prices. But this restores the output back to Ybar more quickly.

Which is worse - unemployment (recession) or inflation?

Fiscal Policy

2008 Tax Rebate and Oil Price Effects on the US in the Near Term

2008 Tax Rebate = $110 bln (compared to $38 blin on 2001 tax rebates)

1975 and 2001 tax rebates: 12-25% and 22% were spent in the first quarter (Poterba 1988 AER; Shapiro-Slemrod 2003 AER)

Thus, 20% of rebates are spent. C rises by $22 bln = 0.8% quarterly = 3.2% annually
C is 70% of GDP, so Y rises by 2.2%

Rising oil price acts as a tax on consumers (trnasfer income to oil producers). US import of oil per year = 4.5 bln barrels.
Oil prices rose by 40% in 2008. Oil "tax" = $180 blin a year (greater than tax rebates!)

Income effects of tax rebates will be larger in shorter period, but high oil prices (if this oil tax remains) will reduce income and consumption in near term, dragging the economic recovery in the near term.

Lecture 9 - The Business Cycle (continued)

2008-05-28T19:45:00.003-05:00

See graph (packet page 8) on the Volatility of Investment and the correlation with GDP.

Investment Volatility

(i) Investment accelerator factor
I (gross investment) = ΔK + λK
where
ΔK is net investment
λK is depreciation
Depreciation is usually about 10%

ΔK = α (K*-K_-1)
where
K* = desired level of K
K_-1 = capital at the end of previous period
α = speed adjustment

If Y, output/GDP, falls by 1-2% in a year. Then K* goes down by 1% (huh?), which is worth about $275 billion.

How does that impact investment? It's nearly 15% of I, investment, because I is about $1800 billion.

So, GDP falling by 1% translates to a 15% decline in investment. That explains the wild fluxuation that we see in the Volatility of Investment graph.

(ii) Postponability

In the real world, you can always adjust and adapt to the circumstances. You don't have to do anything. You can always change direction if there are unfavorable conditions.

Story: 5th ave thrived and 6th ave had nothing, until BB&Y moved in. When BB&Y was successful ("Miracle on 6th St."), it was a signal to the market that the business conditions were ripe for success there.

The moral: When there's investment, they invest a lot. When there's little, there's very little.

The Aggregate Demand Curve

See graph in notes i vs M/P.

What shifts the aggregate demand curve?

(i) Fiscal expansion/contraction: T down or G up
(a) G up leads to AD up (since AD = C+I+G+NX)
(b) T down leads to (Y-T) up leads to C up leads to AD up

In the P vs. AD graph, this is an outward shift of the AD curve.

Fiscal contractions do the exact opposite in the inward direction.

(ii) Monetary expansion/contraction

Let's understand the Monetary Transmission Mechanism

Money supply up leads to Ms/P up which shifts the Ms/P vertical to the right and leads to lower interest rates. Under sticky price assumptions, this leads to r down. C, I and NX go up, and AD goes up - an outward shift.

2 addition channels related to monetary policy:
1. Bank-lending channel. Our consumption is tied to how willing banks are to lend. When banks are risk-averse, they tighten their lending policy and raise lending standards. This is supply side - the supply of loans.
2. Balance sheet channel (financial accelerator effect - Bernanke's term). (Warren Buffet: "When the tide is out, we can see who's swimming naked.") There can be financial distress when there are cash flow problems. Consumption spending will be effected by this liquidity problem.

"Jingle Mail" = mailing the bank the key to the house in lieu of continuing to pay the mortgage.

Aggregate Supply

Long Run Aggregate Supply (LRAS) curve.

Key LR assumption is flexible prices. If you have enough time, prices will adjust. Implications: (W/P) vs L graph in notes.

There is downward rigidity to wages. If the market were fully flexible, we would be at equilibrium and at full employment and full output. This is the U of Chicago view - Robert Lucas.

See graph of P vs Y in notes. Ybar is vertical. Add AD curve. With monetary contraction, AD shifts inward and prices decline.

This theory was tested in the early 1980s by Paul Volcker. Inflation fever was eventually broken, but it wasn't so simple.

Short-run aggregate supply curve (SRAS)

This view is supported by Mankiw (which is strange since he supports Republicans who are usually associated with the U of Chicago economists).

Prices are sticky: Pbar. See graph of P vs Y in notes. Pbar is horizontal.
Prices don't change with change in demand. Rather, supply increases if demand increases.

The truth may be somewhere in between, with P not being constant. It probably slopes upward.

Why are prices sticky?
(i) Menu cost. There's some overhead (cost, inconvenience) associated with increasing the prices and changing menus or shelf price or price stickers or cash register programming.
(ii) Long-term relationship with customers. Customers don't like it when prices go up (or down) frequently.
(iii) Contracts. Companies may be contractually bound to a certain price.
(iv) Strategic pricing decision. In highly competitive markets, one company may wait for the other company to make the first move - leading to stalemate.

Frequency of Price Adjustment
10.2% - less than once a year
39.3% - once
15.6% - 2-3 times

Lecture 9 - The Business Cycle

2008-05-28T18:26:00.003-05:00

The Business Cycle

We graphed GDP (potential and actual) vs. time.

Potential GDP is at full employment and output. Ybar = AF(Kbar, Lbar)

The Business cycle is the regular repetition of the cycle of contraction, recession, recovery and expansion. There's no set amount of time for each of these phases. We want to know: What drives the actual GDP around the potential GDP.

Output gap = Y - Ybar, where Ybar is the potential GDP

Output gap is positive during boom and negative during recession.

How can actual output, Y, be greater than the potential Ybar? Because employment may be greater than the theoretical "potential" by working more hours or if unemployment is lower than the "natural" unemployment. Natural unemployment is the theoretical minimum given that at any point in time some people aren't working because they're changing jobs or just taking some time off for personal reasons.

Business Cycle Indicators

(1) Leading Indicators
(2) Coincident Indicators
(3) Lagging Indicators

(I need some more information about these indicators)

Short Run vs. Long Run

In the long run, prices are flexible and can respond to changes in supply and demand.
In the short run, many prices are stuck at the predetermined level.

Consumer prices do not change immediately after changes in monetary policy from the Fed.

In the short run, prices are stick. (Slow to adjust). Recall the quantity theory of money:
MxVbar = Pbar x Y

If M (money supply) goes up, Y (output) must go up. So monetary policy can be used to affect output activity.

But is the sticky price assumption (in the short run) correct? We will see some data on this.

See the graph: Great Moderation (packet page 6). The business cycle peaks and troughs are much smaller after 1950. Why? Do we have better monetary policy since then? Or perhaps we haven't had severe shocks? Or perhaps pre1950 has less accurate data. (Christian Romer)

See table: Key Characteristics of Recessions in the US (packet page 7). Shows duration and severity of recessions since 1960. Data comes from NBER. The 2001 period is in question whether there was a recession or not.

Unemployment and real personal disposable income and industrial production data indicate that we are now in a recession. See GDP Growth bar graph (pg 9), house-price indices (pg 10, Case-Shiller includes jumbo and sub-prime sales) OFHEO only includes conforming loans (Fannie Mae and Freddie Mac)) and residential investment-GDP ratio graph (pg 11).

Most recessions bottom out with a 2% GDP growth. (is that right? that slide went by way too fast)

When will the recovery happen? U shaped or V shaped or L shaped? Will depend on housing market stabilization/recovery and also how effective fiscal and monetary policies are.

See the table on packet page 8 of the US Economic Outlook.

The AD-AS Model

(1) Aggregate Demand Curve: relationship between P and AD
AD = C + I + G + NX

(i) C = C(Y-t, (y-t)^f, wealth, r)
(ii) I = I(r, Y, Y^f, tax policy)
(iii) NX = NX(ε (minus),Y (minus), Y^foreign(plus))

More on C & I

(1) C - Consumption
In general, disposable personal income is strongly correlated with consumption. But marginal propensity to consume, MPC, may be influenced by age and other factors as well - how much they expect to earn in the future, how much they have now, etc.

Lifecycle hypothesis
forward looking rational consumers will look at all their lifetime potential earnings.
MPC^permanent < MPC^temporary

So, for example, are tax rebates and the "stimulus package" likely to have a big impact? It's $110 billion going to households. In 2001, it was only $38 billion. The 2008 package is temporary. The 2001 rebate was made "permanent" through tax cuts.

With temporary stimulus, we should only expect a 20% MPC. 20% of $110 is $20 billion. This is a 0.8% quarterly increase in the overall consumption, 3.2% annually. This would lead to an increase in Y of 2.2% (Recall that C is 70% of GDP)

Lecture 9 - Exchange Rates (continued)

2008-05-28T17:54:00.003-05:00

Some General Notes

Study notes for the final will be distributed next week.

Some reading links on the course web page are broken and will be fixed

PPP Conditions (cont.):

excahnge rate can be viewed as purchasing power ratio between countries

As a percentage, the %Δe = difference in the inflation rates differencials of the countries

Fixed exchange rate + PPP condition

Fixed exchange rate is a shortcut to fighting inflation.
See chart: Argentina: Exchange Rate and Inflation Rate, 1992-2004.
New president appointed new economist who introduced a currency board: e =1 (Argentine peso/$). A currency board is the strongest form of a fixed exchange rate. It requires the Central Bank to have a $ for every Peso that they circulate.

Under PPP conditions, %Δe = 0 = Π^Argentina - Π^US and therefore the Argentine inflation rate must match the US inflation rate.

Many countries fix their currency exchange rate against the dollar. Some also fix the exchange rate with the Euro as well.

(You can download The Economist screensaver from their web site. It looked pretty cool in class. :)

In Argentina, after they fixed the currency to the $, the eventually (after 3-4 yrs) achieved a low inflation rate.

In the late 1990s, Argentina couldn't sell very much and developed a significant trade deficit. So they decoupled the exchange rate which led to an immediate spike in inflation in 2002. Eventually, the economy stablized and inflation fell back down again.

The Euro

In 1999, the Euro was introduced. 1 € = 1.96 DM = 6.56 FF
ebar = DM/FF = 3.xx
ebar = 0. So, Π^France = Π^Germany

See graph "Convergence of Inflation Rates in the Eurozone: 1970-2007. (packet page 14) Inflation in Germany has historically been low. By pegging to the German currency, other countries "import" the low inflation rate.

Foreign Exchange Background from the Federal Reserve Bank of NY

2008-05-28T15:07:00.002-05:00

For additional reading on the foreign exchange market, I found the following two resources at the NY Fed:

All About…The Foreign Exchange Market in the United States
Discusses in detail the operations, participants and instruments in the U.S. segment of the global foreign exchange market.

All About…The Foreign Exchange Market in the United States
Discusses in detail the operations, participants and instruments in the U.S. segment of the global foreign exchange market.

Lecture 8 - Foreign Exchange Rates (cont.)

2008-05-21T19:37:00.005-05:00

China holds 31% of the US trade deficit. Compare to the appreciation of their currency.
Euro Areas holds about 11%. Japan 10.4%. Mexico 9.5%.

Spot Exchange Rate vs Forward Exchange Rate

Spot exchange rate: Executed immediately.
Forward exchange rate: A future date is specified for delivery of funds.

Why use forward exchange rates?

Suppose you need to make a payment of 1 million Yen in 3 months. If there's a concern that in 3 months the Yen will appreciate, you may want to use a forward contract.

(i) Suppose e = 100 yen/$; you have to pay $10k.
(ii) Suppose the rate appreciates to e = 80 yen/$; you will have to pay $12.5k.
Now,
(iii) If you lock into a forward exchange rate of f = 90 yen/$; you will then pay $11.1k and can be sure of the price. This is a foreign exchange hedge.

This situation involves a zero-sum game. One party always wins and the other loses. There is also a default risk. The futures exchanges reduce the risk of one party running away by requiring a deposit and margin calls (additional deposits) when the chances of losing increase on one side. Transaction costs are reduced by having fixed, standard contracts and regular delivery dates. CME is a major player in this market.

Foreign Exchange Market

We graphed exchange rate (euro/$) vs foreign exchange mkt for $. The supply of dollars is fixed, regardless of the exchange rate and is therefore vertical. The demand for dollars slopes downward since the demand goes up as the (future) exchange rate goes down (relative to today's rate).

What shifts the supply and demand curves?

Demand-shift factors

(i) interest rate differential: iUS-iEuro
If iUS goes up relative to iEuro, then US$ assets become more attractive and the demand for the dollar will rise and the demand curve shifts out (to the right).

(ii) inflation differential: ΠUS - ΠEuro
If ΠUS goes up relative to ΠEuro, US$ assets become less attractive and the demand for the dollar will fall and the demand curve shifts in (to the left).

(iii) (very important) expected future exchange rate
Arbitrage can take place between two places or between two points in time.
Say, for example, the current exchange rate is e=1 euro/$ and you expect the future rate to be 0.5. In such a case, you should by Euros.

In general, if you believe a currency will rise (relative to another), you should buy that currency. Caveat: Since we live in the US, we need dollars for daily living. The above strategy is only for investment purposes.

George Soros profited from currency speculation in UK pound when it collapse on Black Wednesday - Sept 16, 1992.

(iv) Risk of US$ relative to foreign assets

If risk increases, demand for the US$ falls.

* Page 3 of articles: Greenback continues its dramatic slide
*Page 2 of articles: Economic data proves saving grace for yen

100 basis points = 1 percentage point

Carry-trade is a form of arbitrage. In Japan, the interest rate is almost 0%. You can practically borrow money for free. Then you can lend in another place at a profit. (need additional explanation here.)

Purchasing Power Parity (PPP)

Purchasing power parity is a long-run equilibrium condition for exchange. Assume no tariff barriers & no transaction costs.

Arbitrage situation in sweater market between US ($45) and UK (27 pounds). If exchange rate e = 0.7 (pound/$), then 45$ x 0.7 pound/$ = 31.5 pounds. It's cheaper in London!

Buy in London & resell in Chicago. Eventually price in UK will fall and price in US will increase and the arbitrage will stop.

After arbitrage, price will be the same. Equilibrium. No arbitrage condition. e x P-US = P-UK

e = P-UK/P-US

Generalize this to any market, not just sweaters. P-UK and P-US are a price index, like CPI, for a common basket.

%De = %DP-UK - %DP-US
= ΠUK - ΠUS

Higher inflation leads to currency depreciation

Lecture 8 - Foreign Exchange Rates

2008-05-21T18:52:00.006-05:00

As of 5/15/2008,

exchange rate, e = euro/$ = 0.6469

Dollar depreciation makes US products less expensive in Japan, if other things are equal. I.e. for given domestic and foreign price levels.

Real exchange rate ε (epsilon) = e P^US / P^Japan, where e = yen/$.

Ex: Assume Ford Taurus and Toyota Camry are essentially equivalent products.
Taurus: $20,000
Camry: 2.5m Yen

(i) e = 100
ε = e P^US / P^Japan = 100(20,000)/(2.5m) = 2m/2.5m = 0.8

Therefore, the Taurus is cheaper than the Camry.

(ii) e=90
ε = e P^US / P^Japan = 90(20,000)/2.5 = 1.8m/2.5m = 0.72

Nominal depreciation of the exchange rate, makes US products cheaper.

(iii) e=100, but the price of the Taurus goes down to 15k due to innovations and increase labor productivity
ε = 100(15,000)/(2.5m) = 1.5m/2.5m = 0.6

Even without depreciation, US producers can make their products cheaper.

A strong dollar policy was favored by Robert Rubin when he was Secretary of the Treasury and Larry Summers who succeeded him in that position. But a high exchange rate is not always desirable. Italy and Spain are experiencing a recession and do not want a strong Euro.

In general, a strong Euro policy makes sense for them now. It hurts European manufacturing in the short term, but it will help them advance their productivity, which is currently lagging, in the long run. It will force them to innovate. Japan had a similar experience.

Trade balance depends on the real exchange rate, not the nominal exchange rate.

Lecture 8 - Financial Markets (Bond and Stock Markets)

2008-05-21T17:49:00.002-05:00

See packet page 26.

A bond is one specific kind of security.

Bonds are issued by corporations and the government. Fed govt bonds are much lower risk. But corporations and state and local govts can default (Orange County CA, Alabama?).

Stock is partial ownership. It gives the right to vote and may pay dividends. Synonymous with equity financing. The stock market is relatively volatile.

Stock price earnings do not always match corporate earnings. Some justify the stock prices because they reflect future earnings. But that didn't pan out.

Bond holders get paid first, before equity (stock) holders.

Bonds vs Stocks (missing slide?)
The main disadvantage of owning an equity rather than bond is that equity holder is residual claimant. The firm must pay all its debt holders before it can pay its equity holders.

Advantage of holding an equity is that equity holders benefit directly from any increase in the corp's profits or asset value. Debt holders do not share in this benefit beccuase their payments are fixed.

Market capitalization of stocks in the US fluctuates between $1 and $20 trillion, depending...

Financial Intermediaries

Financial Intermediaries pool savings and channel them as loans. Ex: Banks, S&L, credit unions. Fixed rate loans and increasing interest rates (along with the 90-92 recession) caused the S&L crisis. Mutual S&L - depositors are owners. Insurance, pension funds and mutual funds.

Loans account for 55% of business external financing. Small and mid sized businesses don't have the good reputation required to sell stocks or bonds.

There has been many banking innovations in recent years. Regulation Q, commercial paper (now dried up), etc.

Section #4 on packet page 28 was not covered at this time

Bond Markets and Interest Rates

A bond is a debt instrument that promises to make periodic payments (interest payments) until the maturity date, when a specified final amount (face value) is repaid. A bond is essentially an IOU.

3 pieces of information on (coupon) bond certificates: (i) issuing agency or institutions (ii) maturity date (iii) coupon rate & face value.

Most important examples: Treasury securities: T-bills (maturity < 1 year), T-notes (maturity < 10 yrs), T-bonds (10<maturity<30).

General Rule: Bond prices and interest rates always move in opposite direction.

Present Discount Value (PDV)

If you have $1 today and you deposit it for 1 year at 10%. At the end of the year, you have 1+0.10 = 1.10.

Therefore, $1.10 in 1 year is equivalent to $1 today. We say that the present discount value of $1.10 in 1 year is $1.

1.10/(1+0.1) = 1

At the end of the second year, you have $1.10+0.10*1.10 = 1.10(1+0.1) = 1.10²=1.21. Therefore, the PDV of 1.21 in 2yrs is 1.

Generally, PDV of $F in N years = F/(1+i)^N

The larger N is, the smaller the PDV. The value of a billion dollars in 200 years is very little today.

N up, PDV down. i up, PDV down.

Bond Pricing

Consider a three-year bond with a face value of $100 and a coupon rate of 10%. How do we determine the bond pricing?

(i) Assume market interest rate = i = 10%

P_b = 10/(1+0.1) + 10/(1+0.1)² + 110/(1+0.1)³ = 100

Why is the bond price, in this case, the same as the face value? Because the coupon rate is the same as the market interest rate.

Next, assume a case where 1 year has passed. In this case,

P_b = 10/(1+0.1) + 110/(1+0.1)² = 100!

(ii) Now, assume the market interest rate has gone up to i=12%

P_b = 10/(1+0.12) + 110/(1+0.12)² = 96.62

Since the market interest rate is higher than the coupon rate, the bond is worth less.

This supports our general rule: When interest rates go up, bond prices fall.

(iii) If the market interest rate falls to i=8%,

P_b = 10/(1+0.08) + 110/(1+0.08)² = 103.57

As interest rates rise, bond prices fall.

Clearly, if you think interest rates are going up, you shouldn't buy bonds. The longer the maturity, the more you will lose if rates go up. Thus, long term bonds carry a risk in the case where you want to sell before maturity. Even if you keep it to maturity, there is an opportunity loss - you could have done something better with the money.

Lecture 7 - The Federal Reserve System

2008-05-14T19:30:00.009-05:00

The Federal Reserve System (the central bank of the US)

The Federal Reserve System was created by Congress in 1913.

Federal Open Market Committee FOMC, consists of 7 members of the Board of Governors (14 year terms, appointed by the president and confirmed by the senate) and the presidents of 5 of the 12 Federal Reserve District Banks. The NY district is always on the FOMC because they run two important operations: The Open Market Desk and the Foreign Market Desk.

They meet eight times a year (about every 6 weeks) and make decisions regarding the conduct of open market operations, which influence the monetary base. Statements and minutes from their meetings are posted on the web.

Primary responsibility includes controlling inflation or stable price as well as stabilizing economic activity: Humphrey Hawkins Act of 1978

Fed attempts to achieve low inflation by controlling the money supply and short-term interest rates: setting M or i but not both independently.

The Fed's Balance Sheet

Assets:
Securities: US Treasury bonds
Discount loans
Gold and SDR (special drawing rights from IMF)
Coin (Treasury currency held by the Fed)
Cash in the process of collection
Fed's other assets such as foreign currencies, foreign govt bonds, real estates.

Liabilities:
Federal reserve notes outstanding (currency held by the public)
Bank deposits (reserves)
US Treasury deposits
Foreign and other deposits
Other liabilities

Open Market Operations

The Fed increases or decreases the monetary base by selling or buying Treasury bonds through open market operations.

Expansionary monetary policy = open market purchase of Treasury bonds
Contractionary monetary policy = open market sale of Treasury bonds

Open market purchase from a bank has the same effect as purchase from an individual

Fed
Assets +10k bond
liability +10k cash

Individual
assets: -10k bond, +10k cash

What really happens?

After the Fed decides to cut interest rates, they call the open market operations desk (VP of NY fed). They call 30 major bond dealers and tell them that the Fed wants to buy bonds. They keep buying bonds until the interest rate reaches their target. They continue to intervene to keep the interest rate where they want it. They get market feedback every morning, meet around 10 to plan their strategy. After their meeting, they execute their plan and take the afternoon off.

Reserve Requirements

As of Dec 2006, the reserve requirement on demand deposits was 0% on the first 8.5 million, 3% on those between 8.5 million and 45.8 million and 10% on those in excess of 45.8 million.

If the Fed reduces the reserve requirement, then the money stock will rise and vice versa.

However, the Fed rarely changes this because it would require significant alterations in banks' portfolios, so it would be disruptive if it changes frequently.

Discount Rate

Suppose that a bank finds itself temporarily with fewer reserves than those required by the Fed. Instead of forcing the banks to reduce loans or investments, the Fed could lend money to the bank to meet the required reserve ratios, and charge interest on the loan. The process is called borrowing at the discount window and the interest rate is called the discount rate.

Two ways to use this tool: change the discount rate or limit how much they can borrow at the given discount rate. today this is used mostly to help or discipline a particular bank.

Banks have developed their own way to meet their reserve requirements. Rather than borrowing from the Fed (and possibly being subject to increased scrutiny), banks short of reserves can borrow from other banks that have excess reserves. This market for reserves is called the "Federal Funds Markets" and the interest rate charged is called the "Federal Funds Rate" - interbank loan interest rate. (counterpart in London, LIBOR (London interbank offered rate)).

Fed's Activity during credit crisis of 2007-08

Fed cut interest rates seven times to 2% (as of May 12, 008) from 5.25% in September 2007. With rescue of Bear Stearns in mid-March, Fed started lending to prime dealers and investment banks against collateral of martgage-backed securities. Fear of financial market meltdown easing.

2 functions of the Fed:
(1) Monetary policy: change the size of money supply (i.e., federal funds rate) - expansion & contraction of Fed's balance sheet

Three important assets:
1. Securities held outright (system of open market account SOMA - entirely Treasury securities $703bn out of $898bn total assets of Fed)
2. Securities held under repo agreement (treasuries, GSE-agency bonds and agency MBS, $77bn)
3. Discount window lending ($60bn)

(2) Lender of last resort (liquidity and financial stability): To promote liquid and functioning markets, Fed can change the composition of Fed's balance sheet, not the size. Take out of favor assets into its balance in exchange for Fed liabilities.

Examples: (i) TAF (term auction facility - discount window): Fed lent funds to depository institutions against a broad range of collateral that the borrowing institutions have pledged to the Fed ($100bn for 28 or 35 days in March 2008). To offset the increase in the balance sheet, Fed has had to reduce Treasuries under SOMA.

(ii) TSLF (term securities lending facility): Under the new facility, the 20 primary dealers will be allowed to exchange mortgages (GSE agency mortgages or private label RMBS) for Treasuries that the Fed holds in the SOMA ($200bn for 28 days).

(iii) Expansion of term repos: On March 7 Fed announced an intention to ...

Hyperinflation

Hyperinflation is defined to be inflation that exceeds 50% per month, which is just over 1% per day.

Why central banks in countries having hyperinflation chose to print so much money in the first place?

Govt can finance its spending mainly through 3 ways:
1. tax revenues
2. borrowing from the public: issuing govt bonds
3. seigniorage: monetary finance. simlpy print more money to finance the spending

Most hyperinflation begins with...

Primary budget deficit = G-T
Total budget deficit = G-T-i x D_-1(interest payments on existing debt outstanding)

D-D_-1 is the new issues of govt bonds.

(i) who buys bonds? D = D^{Central bank} + D^public
(ii) D = M^h - B^CB/e + D^public
see derivation

The Central Bank Independence and Politics

Rapid increase in money supply can produce high inflation that destabilizes the economy.

Controlling the money supply is the crucial job of the central bank.

Yet the central bank faces many powerful political forces that put continued pressures on it to extend cheap credits, or to help finance a large budget deficit. Thus it may be hard for the Central Bank to resist these political pressures unless it has some institutional independence from the government executive and legislative branches.

Therefore, in the pursuit of low inflation, there are advantages to having an independent Central Bank. Also, an independent Central Bank may possess greater credibility once it commits to lower inflation, compared to a Central Bank that is heavily under the influence of elected policymakers.

Data (graph, page 23) shows inverse relationship between avg inflation and index of central-bank independence among major countries. I.e. lower independence is associated with higher inflation.

Lecture 7 - Money (continued)

2008-05-14T17:38:00.002-05:00

Some preferatory remarks:
To have a low interest rate, you need a larger money supply. You can't change one without the other. Increased money supply always shows up as inflation. We will see how the money supply is controlled.

Velocity of Money

V = PY/M = nominal GDP / M

Recall: GDP deflator (P) = Nominal GDP / Real GDP (Y)
Therefore, nominal GDP = PxY

Velocity is how many times the money changes hands to get to GDP.

Latest data: 2006 nominal GDP 13.2Tr. V or M1 = 9.6. V of M2 = 1.96.

Quantity equation: M x V = P x Y

Assume V is constant

(i) M x Vbar = P x Y
(ii) In the long run, Y = AxF(K,L)

If the money supply M increases, it must show up in an increase in P, prices. (Unless K and/or L work to increase Y)

This is known as the quantity theory of money.

In %Δ - %DM + %DV = %DP + %DY

%DP is inflation, denoted at Π

Therefore, Π = %DM - %DY

%DY has historically been about 3% in the US.

Any money supply increase over the GDP growth rate will show up as inflation. This is the primary driver of inflation - excessive monetary growth. Other sources of inflation are: Cost-push inflation, demand-pull inflation (seen after the collapse of Soviet Union).

The assumption was that the velocity of money is constant. Data shows (Table 1) that %DY is about 0.1% on average from 1960-2006. Monetary innovations such as debit cards and ATM
machines have impacted the velocity of money.

Friedman: Inflation is always and everywhere monetary phenomenon.

So why can't we easily control inflation through monetary policy?
Forecasting - We'd need to know the growth rate accurately in order to control the money supply correspondingly.
Time Lag - money supply changes effect the economy with about a year lag

Cross-country data supports the connection between money supply and inflation.

Nominal and Real Interest Rates

Fisher Equation: i = r + Π
i = nominal interest rate
r = real interest rate
Π = actual inflation rate

In practice, i = r + Π^e, where Π^e = expected inflation rate, since Π is not known in real time

The Fisher effect: one-for-one relationship between the inflation and niominal interest rates.

Using the Fisher equation, we see that monetary growth leads to inflation which leads to interest rates rising. Data since 1980 shows this correlation.

Liquidity Preference Theory

Determinants of money demand: (i, Y)
(i) i = opportunity cost of holding cash (nominal interest rate). We can graph this relationship - negative correlation between i and Md (money demand) If interest rates go down, money demand goes up.

What's the main purpose of holding cash? As a medium of exchange.

Dividing M by P (price level) makes this graph more meaningful.

If Y goes up, income goes up, and real money demand goes up and the (M/P)^d curve shifts to the right.

Money Market Equilibrium

See graph 3

Equilibrium is achieved when (M/P)^s = (M/P)^d
This occurs at interest rate i*.

At i₁, there are high interest rates and there is excess supply of money. Eventually, this excess supply will drive interest rates down.

Similarly, at i₂, there are low interest rates there is excess demand.

Notation: Real Monday Demand = L (i,Y)

If the Fed increases the money supply, the money supply vertical shifts to the right (monetary expansion). A new equilibrium point is achieved, with a lower interest rate. (see graph 4)

Timeline: Over time, other things will change and interest rates will not remain low after a monetary expansion.
(i) in the intermediate run (around 5 yrs), low interest rate will encourage consumption up, net exports up(via e down) and investments up. Therefore, output Y will increase because Y = C+I+G+NX. This causes a rightward shift to the money deman curve and a new equilibrium (3) is achieved.
(ii) in the long run, MxV=PxY and the ultimate result of increase money supply will show up in increased prices, P. This will drive interest rates even higher (i4 on graph).

Monetary policy is used to control and prevent these escalating interest rates in the intermediate and long run.

Refer to US Monetary Aggregate M2 (annual percent change) vs Federal Funds Rates 1960-2007 graph. It shows that they move in opposite directions.

Midterm Answers

2008-05-08T12:26:00.002-05:00

I hope everyone did well on the midterm. My thoughts are that some questions were fairly straightforward, especially part 1, but others really made you think and analyze. I thought it was pretty tough overall, but I think/hope I did pretty well. The analysis and short-essay format was fairly new to me. I usually do better on objective tests where it's clear right/wrong answer, but this essay format is more challenging.

I won't be posting the answers to the midterm. If you have questions or want to see my answers, send me an email.

Lecture 6 - Money, Inflation and Interest Rates

2008-05-07T20:19:00.002-05:00

Introduction

See graph of inflation in industrial countries. It peaked in 70s at 8.7%, but has subsided since then to less than 3%.

Greenspan kept interest rates low in 2002 and 2003. Fueled the housing bubble. Interest rates were way below what the Taylor Rule would indicate.

Money supply is directly related to interest rate. Low interest rates require more money supply which leads to inflation.

Fed mandate: control inflation and control business cycle (overheating). European Central Bank (ECB) is more obsessed with maintaining a low (~2%) inflation rate because that is their sole objective.

Discussion of two types of bonds: nominal (which don't adjust for inflation, but are purchased at a discount) and TIPS inflation-adjusted bonds. The gaps between them represents what the public anticipates in inflation. (??)

What is the function of money?

(1) Medium of exchange. Without it, we only have barter which requires a "double coincidence of wants".
(2) Store of value. non-perishable.
(3) Unit of account. It makes it easy to compare prices. It's a common good against which all other goods are valued.

Other things can be a store of value (#2), but these are not equally easily exchangeable for other goods.

Therefore economists measure the liquidity of an asset = ease and speed with which an asset can be traded for other goods.

The Measures of Money (in the US)

Very liquid assets = cash or anything "close" to cash should be considered as money

C = currency
M1 = currency + demand deposits + traveler's checks + other checkable deposits
M2 = M1 + money market mutual funds shares (checking acct against mutual fund shares) + savings and small time deposits (<$100k CDs) + overnight repurchase agreements (overnight loans collateralized by treasury bonds)
M3 = M2 + large time deposits + term repurchase agreements
(+ Euro dollars - i.e. dollars circulating outside the US, not just Europe) short discussion of regulation Q.
L = M3 + short-term Treasury Securities + other liquid assets

Lecture 6 - Productivity and Growth (cont.)

2008-05-07T17:52:00.004-05:00

Productivity slowdown and real wage slowdown in 1970s and 1980s

Compared to 1950-1972, all OECD nations experienced a slowdown after 1973 until 1994. See table 3, page 9.

Key questions:
Why did this happen?
Why did the US pick up after 1995 and other European nations didn't?

Labor Productivity Model

We graphed real wages (W/P) against labor supply and demand, L. L_S is assumed constant against wages and is therefore vertical. Labor demand increases with decreasing wages. There's an equilibrium point between the L_S vertical and the L_D line.

Labor demand is represented by MPL - the marginal productivity of labor. MPL=ΔY/ΔL. Average labor productivity is Y/L. MPL moves, in general, with Y/L. If Y/L is down, as it was in the 70s and 80s, MPL will shift down too.

What happens to the equilibrium when MPL shifts downward? There are two possibilities:

If the labor market keeps the labor supply at the same size, wages will go down. This is the case in the US.

However, if the labor market is more interested in wages staying the same, then the labor supply will shrink, i.e. unemployment will increase. This is the case in Europe. In Europe, the strong labor unions demand constant high wages. This comes at the expense of increased unemployment in Europe, as the data in the graph shows. High hiring costs tend to keep the unemployment rate somewhat permanent.

Look at the annual turnover of firms in manufacturing. From 1989-1994, the rate in France and the UK was 22-23%. Very dynamic. US was 18.5%. Italy and Germany were lower than the US. US is not an outlier.

In net employment gain in manufacturing after 2 yrs, US is at 134%; while European countries are around only 5-23%. This is due to the barriers to hiring in Europe. These hiring barriers may also impact the willingness of European firms to adopt new technology since they would need to hire more and more skilled workers.

Why was there a worldwide slowdown in productivity?

1. Composition of labor force has been changing. Babyboomers entered the workforce. They are less experienced and therefore less productive.
2. Increasing government regulations. For example, environmental protection and workplace safety. These both impact productivity, even though they are good causes.
3. Oil price shock. Sharp increases in oil prices may have made some of the capital stock permanently obsolete. However, since 1985 until recently, there have been large oil price decreases, yet the productivity growth revived only in manufacturing sector. (So this is not a satisfactory answer on its own.)
4. Could it be that the world has run out of new ideas about how to produce? Although computers and IT technology are significant innovations, it seems that they are only beginning to yield significant productivity gains, mainly in the manufacturing sector. Computer/IT technology only show up in the data after around 1995. This lag between invention and higher productivity is not unusual. (See the stages of technological revolution below.)
5. Mis-measurement of output growth and productivity. Perhaps we should measure the quality of products instead of the number of products. Health care and financial services have improved, but how do we capture that?
6. Lower saving? Less investment in new innovations.

Information Technology and the New Economy in the 1990s and 2000s

Labor productivity growth in the non-farm business sector increased from about 1.5% in 1973-95 to 2.5% in 1995-2000. Since 2000 (through 2004), it averaged about 3.4% per year. Perhaps as much as half of the acceleration came through increasing IT capital per worker - capital deepening - and about a quarter of it through improvements in the efficiency with which IT goods were produced.

Nominal IT investment increased from 1987-95 to 1995-1999 (9.3 to 16.6). Some connect this investment to the growth in labor productivity and conclude that IT caused an increase in labor productivity throughout the economy. Examples: Dell, Amazon. It changed retail purchasing and delivery model. See graphs on page 12 of packet, based on McKinsey (2002) "How IT Enables Productivity Growth".

But it's not so simple. See "How IT Changes US Productivity" by McKinsey (2002) (I could not locate this publication online) and the graph page 13 in packet. They found only 6 "jumping" industries that benefit greatly from the IT investment. But others, such as agriculture, may actually see negative growth despite increased IT investment.

Historical Perspective

How does Information and Communication Technology (ICT) compare to the greatest inventions of the 20th century: steam power, railway, electricity, etc.?

The recent boom and collapse in ICT stock prices and in spending on goods embodying new technology is typical of technological revolutions.

Example: the railway system in London in 1840s. The expansion was fueled by stock investment boom, followed by stock market crash, but the late 19th century continued to benefit from this innovation.

3 typical stages of technological revolution:
Stage 1: Productivity growth in innovating sector (e.g. computer manufacturing industry)
Stage 2: A fall in price of innovation that encourages its wide use by business or consumers (also accompanied by wage increases since workers are more productive)
Stage 3: Production in all sectors reorganize around the innovation that embody new technology
leading to broader-based surge in productivity. (this may be where we are today with IT)

It seems that the US is now just entering the 3rd stage.

Comparing Countries

See table 4 on page 16 of packet, comparing GDP per capita (PPP) of selected countries in 1950 and 2000. Look at Ireland and Japan. Rapid growth rate enabled them to close the gap. The beauty of compound interest!

Notes on these data: Comparing GDP based on exchange rates can be misleading because the CPI in one country may be different than another. Therefore the PPP takes this into account to calculate a "purchasing power parity" statistic.

Absolute Convergence Hypothesis

Poor nations have lower (K/L), but higher MPL.
Two reasons for absolute convergence:
1. Law of diminishing marginal product of capital stock
2. don't need to reinvent wheeel: advantages to second comers. take advantage of foreign advanced tech (copy, adopt and assimilate...): improve A

conversely, rich countries would eventually

Plotting GDP per capita growth vs. GDP per capita, we would expect a negative correlation, but the scatter plot doesn't support this theory. There's no correlation. We need to reexamine the hypothesis.

BTW, among OECD countries, Korea, Ireland and Portugal have highest real per capita GDP growth.

Conditional Convergence Hypothesis

Whether poorer countries can grow faster and hence catch up with richer countries or not: It turned out to be conditional on having good policies and institutions in place such as:
- investment in education, see panel 3
- investment in physical capital stock, see panel 4
- trade openness, see panel 5 (there are other geographical factors)
- stable macroeconomic management (low inflation, low budget deficits, stable exchange rates)
- quality of public institution, see panel 6, related to expropriation risk

We actually find poor nations lending to richer nations (like China to US). Why not just invest it internally? Because of all the risks involved. Even though returns in US may be less, the risk is less too. The risk-adjusted rate of return in poorer nations is actually pretty low.

Global imbalances and capital flows graph shows that the US and G7 nations (except Japan) are borrowing heavily and the loans are coming from emerging and developing nations. The e&d nations don't have enough capital flows that would help them grow because of all the risks they have.

Lecture 5 - Productivity and Growth

2008-04-30T19:45:00.004-05:00

Productivity and Growth

Graph of potential GDP and actual GDP. Actual dipped during the great depression, but went above the line during and after WW2.

Used logarithmic scale to create a linear graph, but the actual graph is exponential. Rapid growth or decline is even more dramatic in reality.

Rule of 70:
Number of years to take to double in size = 70/annual growth rate (in percent)

Example: If an economy grows at 2% each year, then it would take about 35 years to double. or equivalently, every 35 years it would double. If this economy grew just 1 percentage point faster, at 3% each year, then it would take just 23 years to double.

Einstein called the discovery of the power of compounding is the greatest discovery.

Growth and Living Standards

What matters for living standards is per capita GDP = GDP/population

Let Z=X/Y
Then %dZ = %dX - %dY

Therefore, %d percapita GDP = GDP growth (3.09%) - population growth (1.27%)

What drives our standard of living? Is per capita GDP a perfect measure of living standards?

How about crime, pollution, the beauty of the landscape, income distribution across the population? Nonetheless, GDP per capita is the best measure of economic well-being for practical reasons.

The key is labor productivity. So the question is: what drives labor productivity growth?

Power of compounding:

In 1870, UK GDP per capita > US GDP per capita by 18%
In 1990, US GDP per capita > UK GDP per capita by 50%

This dramatic shift in living standards came about with less than 0.5% difference! In 1870-1990 UK growth rate of per capita GDP - 1.37%, US growth rate - 1.85%.

In 1950, UK GDP per capita > German GDP per capita by 57% (due to WW2)
In 2000, German GDP per capita > UK GDP percapita by 3%

It came from 1% point difference in growth.

Growth Accounting Equation

Y = AxF(K,L)

The production function can be influenced either by increasing capital K or labor L. The technology (overall efficiency) factor A might also go up, which would increase output Y.

Corruption diverts the talents and resources from improving overall efficiency A. This is what is causing several Latin American countries from maximizing output despite an abundance of capital stock K and human resources L.

A is also called TFP = total factor productivity.

See Mankiw (p 244) for the derivation of the growth accounting equation.

Y = AxF(K,L) ~ production function (level form)

How do we express this in terms of % change?

%dY = %dA + α%dK + (1-α)%dL

where
α = capital income share = 0.3 in US
1-α = labor income share = 0.7 in US

This equation can be used to explain the percentage contribution of each factor to the overall output growth. See table 1 in the handout. Surprisingly, TFP declined in 70s and 80s. Labor growth grew due to the baby boomers, women and teenagers entering the labor market.

Labor Productivity: The Key to Rising Living Standards

Productivity of labor = Y/L (the quantity of output per unit of labor)

Consider living standard as measured by Consumption/person.

Assume consumption is only some %age of total output: C = (1-s)Y, where s = savings.
Then,
C/person = (1-S)(Y/person) = (1-s)(L/person)(Y/L), where L is labor.

How can we increase C/person?
(i) reduce S (savings rate). but this is at a cost of future consumption. (Recall S=I, therefore S down leads to I down leads to K down leads to future consumption down)
(ii) raise (L/person) - the labor participation ratio. But this is not always desirable. It's limit to 100%. It comes at the expense of leisure time.
(iii) raise (Y/L) - labor productivity. This is the key!

See Paul Krugman's Age of Diminished Expectations. He understood this.

What determines labor productivity growth?

Recall: %dY = %dA + α%dK + (1-α)%dL

Let's rewrite this in terms of %d(Y/L) = %dY - %dL

So %dY/L = %dA + α%dK + (1-α)%dL - %dL
= %dA + α%dK + -α%dL

Regrouping,
= %dA + α(%d(K/L))

K/L is capital stock per worker

So labor productivity can be improved by:
(i) increasing K/L - capital stock per worker. This explains why well-equipped Americans have higher productivity than poorly-equipped African workers.
We can achieve K up through increasing I. Recall that S=I, so increase I by encouraging increasing savings, S.

Feldstein-Horioka puzzle found that S and I move closely together as if they're in a closed economy.

S^g is the fiscal burden from population aging.
Social Security benefit is a pay-as-you-go/funded program. Elders are paid as young ones are paying.

(ii) increase productivity A
1 - one way to increase productivity is to improve the inputs through education and training - investment in human capital. A year of schooling tends to increase income by 8%. MBA, even more so. :)
2 - another way to do increase productivity is to improve production technology

See Table 2 in handout (page 8).

Rapid productivity growth in US in 60s, but then it fell for 3 decades due to falling TFP and captial per worker.

Lecture 5 - The Great Thrift Shift

2008-04-30T18:07:00.004-05:00

The US trade deficit of >$800 billion seems unsustainable. It requires the US to borrow from foreign nations. At some point they may not want to continue funding our trade deficit.

Ben Bernanke argued that we don't need to worry about it because foreigners have a lot of money to lend.

It now appears that he was wrong due to the financial markets crisis. Perhaps we can't pay it back, just like the housing crisis shows.

Why didn't interest rates rise?

Around 2000 in the US:
(i) Fed cut interest rate very aggressively
(ii) Bush administration: Taxes down, Govt spending up
Decline in private savings and govt budget deficit

Since US is 1/4 of world economy, it should have a major impact - an inward shift of world savings. See Economist article.

This should have caused an increase in interest rates, but it didn't!

The explanation is that world investment collapsed much more than the world savings fell.

Now the question remains:
Why did Investments, I, collapse more than Savings, S?

(i) Look to East Asia

Recall: S-I = NX

Since this region was growing rapidly (10%) in the 1990s, investors were happy to invest (despite risks). Example: Samsung going into auto manufacturing. However, the investment market reached a peak in 1996 and the beginning of 1997. 40-50 companies went bankrupt every day. It was bad quality investing. Default risk was high and came about. The risk of changing currencies and interest rates also caused insolvency.

After the financial crisis in 1997, investment has gone down by 10% of GDP in the region.

(ii) Japan: they're in a >10 year economic slump. Due to consumer and corporate default on loans. Investment remains low. Their engine of growth is foreign exports.

Economic strategy: Japan grew spectacularly after WW2 due to increasing exports. To sustain this, they made sure their currency wasn't overvalued. They intervened in foreign markets by buying foreign assets and selling domestic currency.

East Asia and China learned from this lesson of Japan. China's consumption is only about 38% of GDP.

(iii) US & Europe: IT investment boom collapsed around 2000-01.

8% (trade deficit of GDP??) is the dividing line for risk to foreign investors.

Why the global imbalances?

i.e. How does the US trade deficit boom while many nations are running a trade surplus? The US trade deficit has only gone over 3% over the last 5-6 years.

A - US
(i) Fed's low interest rate
(ii) Taxes down, govt spending up
1 personal savings is way down, consumption up: on the back of low interest rates, low taxes - causing housing boom and stock market investment increase
2 Govt savings way down. therefore overall S is way down and I is down, leading to NX down. i.e. increase in trade deficit

B - East Asia and Japan: investment collapse, I down. So, S-I=NX and NX is down too.

It started from the US policy reaction, but was fueled by the foreign willingness to invest.

Since 2000, two new elements:

1. China. In 2000, S=12% of GDP. In 2004, I=46% of GDP, S=50% of GDP. China invests a tremendous amount, but they save even more! They run a massive trade surplus.

2. Middle East and Latin America. Oil revenue and other commodities (raw materials) boomed. They learned from other countries not to squander the windfall gains.

Question: How do we define a global economic balance?
Answer: When every country has more or less balanced trade. But the extremes that we are experiencing these days is very imbalanced.

Midterm

2008-04-30T17:54:00.004-05:00

The midterm exam was distributed tonight in class.

Directions/Guidance:

It is a take home exam.
Due next week - May 7 at 5pm - via email.
Must be typed, not handwritten.
Save as MS Word doc (not 2007 though).
Refer to any textbook, handouts, any other sources, but not other students. It must be from your own thinking. Do not discuss the exam with anyone under any circumstance.
Warning: Sources available on the Internet are not always reliable! Use caution with them. It's better to rely on the information conveyed in class, in the readings and from your own thoughts.
Be reasonable in the length of your answers. The quality of the answer is what matters.
Expectation is to spend about a half day on this exam. That's what it should take if you've kept up with the readings.
It will take more than one week for the exam to be graded.
The number of points possible is 95. The midterm counts for 40% of the final grade.
Sources of common information from class (S-I model) do not need to be quoted. But if you are making an argument based on some other material, you may quote it. But it's risky! It's better to base your arguments on standard theory.

Lecture 4 - Saving, Investment and Trade Balance in an Open Economy

2008-04-23T18:36:00.008-05:00

Output in an Open Economy
Recall the national economy equation in an open economy (including net exports):
Y = C+I+G+NX

Derivation
Y (output) = total expenditure on domestic goods and services
= C^d + I^d + G ^d + Exports
where d denotes domestic consumption, investment or gov't purchases

= C-C^f+ I - I^f + G - G^f + EX
=C + I + G + EX - (C^f+I^f+G^f)
that last term is all the imports
= C + I + G + EX - IM
= C + I + G + NX

NX = EX-IM = net exports = trade balance

NX = Y - C - I - G
NX > 0 indicates a trade surplus
NX < 0 indicates a trade deficit
NX = 0 balanced trade

(ii) Y-C-G-I=NX
(Y-T-C) + (T-G) - I = NX
S^p + S^g - I = NX
S - I = NX

We run a trade surplus if NX > 0, which means S > I
We run a trade deficit if NX < 0, which means S < I

Savings, Investment and Trade Balance

S - I = Net foreign lending
= amount of money we lend abroad - amount of money foreigners lend to us
NX = Net exports = Trade balance
Thus, S-I=NX implies that international flow of capital and international flow of goods & services are two sides of the same coin

Trade deficit: NX < 0
Import more than export
Someone needs to pay for the gap
Pay by borrowing form abroad (S-I < 0)

When running a trade deficit, we finance the deficit by borrowing the equivalent amount from abroad, and vice versa.

The borrowing can take many different forms: straight loans, gov't bonds, corporate bonds, etc. There was a brief discussion of foreign investment limits, particularly real estate and the Chicago Skyway leased to Macquarie.

Twin Deficits
(see Mankiw page 129)

Gov't deficit and trade deficit.
Mechanism:
Consider the savings-investment (S-I) model in a small open economy, under free capital mobility.

(i) Ybar = AxF(Kbar, Lbar)
(ii) S - I(r) = NX (investment is a fxn of the interest rate)
(iii) r = r^world
since we're assuming it is a small open economy the domestic interest rate (and banana prices) will be dictated by the world interest rate (and worldwide price of bananas).

If the equilibrium interest rate is the same as the world interest rate, there will be a trade balance. If the world interest rate is higher, there will be a trade surplus (NX>0). If the world interest rate is lower, there will be a trade deficit (NX<0).

Model:
(see packet page 15)
Assume that initially the economy is at equilibrium and that the govt has a balanced budget. Then assume that the govt pursues fiscal expansion (G up or T down). Then the saving (S) curve will shift to the left. But the interest rate can't go up since it's dictated by the world interest rate!
This will create a gap between domestic savings and investment. We will end up with NX < 0 - a trade deficit!

Data:
(see packet page 17)
In the 60s and 70s, we had mostly a trade surplus, and the federal budget deficit was kept to 3% or less. In the mid 80s, the trade deficit jumped up to 2-3%. At the same time, it was matched by an increase in the federal budget deficit of about 2-3%. Decline in budget deficit in the late 80s was matched by a decline in the trade deficit.

But in the late 90s when Clinton cut the federal deficit and actually created a surplus, it was not matched by a similar movement of the trade deficit. Rather, the trade deficit continued to increase.

Explanation of the model break down
Why did the twin deficit mechanism break down in the 1990s? Because the model assumes "other things being equal". Private savings, private investment were factors.
(i) the twin deficit mechanism tells us that if S^g goes up (govt budget deficit reduction), then S overall increases and NX increases. But that didn't happen!
(ii) Instead, S^p went way down, i.e. household savings plummeted. I (investment) increased due to the IT investment boom. As a result, S overall went down, I increased. Therefore, S-I=NX went down and we saw increasing trade deficits.

Why did private savings go down? Because of the stock market boom and low interest rates.

(See Whatever Happened to the "Twin Deficits" - Chapter 2 of Is the US Trade Deficit Sustainable by Catherine L Mann)

Balance of Payments System (BOP)

The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time.

BOP consists of subaccounts:
current account: accounts for flows of goods and services (imports and exports) sometimes called "above the line items"
capital account: accounts for flows of financial assets (financial capital)

(See BEA, Survey of Current Business, March 2008 data for 2007)

Current Account
2007 US trade deficit was -708 billion. Current account deficit was -738 billion.
Current account deficit = Trade balance+Net Foreign Receipts+Unilateral current transfers (international charity)

In the US, current account and trade deficit are used interchangeably. But in some countries like Czech Republic and Ireland (the "Celtic Tiger"), they have a trade surplus, but because of the Net Foreign Receipts they end up with a current account deficit.

Capital Account

Increase in US holdings of foreign assets = 1206 B
Increase in Foreign holdings of US assets = 1863 B
Net = 657 B

There's a 81B$ statistical discrepancy between the current account balance and the capital account balance. This is due to various different measurement errors that go into these enormous calculations which are really estimates, not exact accountings. It may also be explained by the underground economy. The statistical discrepancy is growing from year to year.

Exchange Rates

When the capital account measures the foreign holdings of US assets, the transactions are in dollars. Fine. US holdings in foreign assets, the transactions are in foreign currencies and must be converted to dollars using the exchange rates. Dollar depreciation impacts this accounting. There is a question as to how long the foreign investors will continue to finance our trade deficit with their investments since they often lose money on the transactions due to the falling dollar.

Consumption and the Balance of Trade

Trade deficits could be worrisome, if C is the main cause.

(i) In a closed economy, if C goes up, S goes down. Since S=I, I goes down, leading to K (capital stock) going down, which will cause C to go down in the future.

(ii) In an open economy, if C goes up, S goes down. Since S-I=NX, NX will go down. Then we will pile up foreign liabilities which will need to be paid back eventually.

Australia and Canada have run a big trade deficit for many years and financed it through foreign investment (not loans). In other countries, like Argentina, the investors have panicked and pulled out. 8% of GDP for a trade deficit is the threshold beyond which investors consider it a big risk to continue investing.

Researching Social Security

2008-04-23T17:19:00.004-05:00

Now that you've seen how to use the Depaul Online Research Library in the previous post, I'll show you how to use it to research a particular topic, Social Security. (I chose this example because my group's project has to do with Social Security.)

Finding and Using the CCH Human Resources Database
One of the best resources for information on Social Security is the CCH Social Security Reporter. (Full Disclosure: I work for Wolters Kluwer, the parent company of CCH.)

1. Bring up the main DePaul web site by browsing to http://www.depaul.edu.
2. At the top of the page, click on the "Libraries" link.
3. On the Libraries page, in the Research section (top left), click A-Z library list.
4. Scroll down to library 43 - CCH Human Resources. Click the link. You will be prompted to log in with your Depaul student ID and password and then be forwarded to the CCH HR Library. Since CCH doesn't get your Depaul ID info, they will prompt you for an email address so they can identify you the next time you visit and maintain your site preferences if you set any.
5. On the CCH HR Library page (the CCH Internet Research Network), select the Payroll tab and then scroll down to the Social Security Reporter section.
6. The Social Security Reporter has over 14000 cases in the case table. The Benefits Explained section has a paper on Financing Social Security. The Benefits Explained subsection within the Benefits Explained section has a section on Retirement and Survivor Benefits which has details on the Old-Age Insurance Benefit, which is what I think most people think of when they think of Social Security benefits.

How to Use the Depaul Online Library for Research

2008-04-23T17:13:00.003-05:00

span style="font-weight: bold;">DePaul Online Research Library
One of the really nice perks that we have as students at DePaul is the online research library. The library subscribes to many databases of academic journals and magazines which are searchable. Many of these databases allow you to access and download full text versions of the journal articles, usually available in PDF format. To access the online research library, all you need is your Depaul student ID.

Here's how to access the DePaul online research library:
1. Bring up the main DePaul web site by browsing to http://www.depaul.edu.
2. At the top of the page, click on the "Libraries" link.

3. This will bring you to the Library page. There are lots of links to follow here. Focus on the "Research" section. The way this works is that you need to identify the database in which you want to conduct your search. Once you do that, you can use the database's internal search function to find your article. So, how do you find a database? There are a couple ways:

Method 1:
Use this method if you're just starting out and don't know which database or journal you're going to search
4. Click the "Journals and newspaper articles" link. That will bring you to the subject page.
5. Since we're studying statistics, a good choice for subject would be Mathematical Sciences. Click that link.
6. You get the database list. For mathematical sciences, we subscribe to 7 databases. The database list gives you a short description of the database and the dates covered by the database. Some of the databases indicate whether we subscribe to full text of articles with a FT icon:

7. Choose your database and click on its link. You'll be prompted for your DePaul username and password. Enter those and click Login.

Method 2:
Use this method if you know the database you want to search
4. In the Research section of the Library page you can click on the A-Z Database List to see all the databases. If you already know the database that you want to search, you can skip by the "subject" steps 4-5 above in method 1 by just using the A-Z list.

Method 3:
Use this method if you know the name of the journal that you want to search
4. Click the "Journals and newspaper articles" link.
5. On the left hand margin, enter the name of the journal and click Search.
6. The results page will show you which databases contain that journal and for which years

Each database has its own interface and it would be impossible for me to cover all of them, but most of them are self explanatory and user-friendly. You can usually search by author, article title or keyword. Several databases also allow you to browse the issues of the journals in the database.

How to Write a Group Paper

2008-04-23T17:11:00.003-05:00

Writing a paper as a group can be a difficult task. Here's the process that we're using to write our group paper. You may find this helpful in managing your own group project. If you have any suggestions or recommendations, feel free to comment or send an email.

1. Form a good group. Look for people who are at the top of their game intellectually and seem interested in the class. The gal in the front row with her hand up all the time is a a better choice than the slouching guy in the back of the room who's nodding off during the lecture.

2. Pick an interesting topic. At least one person in the group should have some significant passion behind your topic. It would be best to have at least one person who works in that industry. So, if you're going to write about the Fed, try to find someone who works there! Even if he's not directly or even indirectly involved with setting interest rates, chances are good that he can get some good information from the people he works with.

3. Narrow the topic to something very specific. Getting as specific as you can will help you focus your efforts. Of course, don't get so specific that you're unable to find material on the subject. Choosing something timely and popular will make material easier to find.

4. Write an outline with the entire group. You're gonna need your standard introduction, body and conclusion, of course. Break out the body into 3-5 sections. Most topics will have a history section where you review the history of the issue at hand. Then you might review different views of experts on the current issue. Lastly, you'll probably want to assess each of those views in your own opinion. Draw some conclusions and set it up for your concluding section.

5. Assign the sections of the outline to the members of your team. If anyone has a preference, try to honor it. It's always better to have someone writing on something that they feel comfortable with and that they're interested in. Each person should have ownership and responsibility for their section. That said, everyone should be willing to help out with any section, as needed.

6. Pick a collaboration tool. I prefer GoogleDocs. There's also Microsoft Office Live. You could also use any web-based tool/site that allows you to upload and share a document. You want to be able to share a common document so there's visibility into the progress of the entire progress. You don't want to find out that one section isn't progressing at the last minute. In addition, you'll be easily able to help each other out with content and form as well as double-checking spelling and grammar.

7. Gather source materials and cut/paste them (or links to them) into the project doc at the bottom. This should take at least a week. Don't worry about writing anything during this time. Just gather information.

8. Refine the outline and cull the information that you've gathered. You probably won't use all of the information that you gathered. Despite how interesting some material may be, resist the temptation of including it unless it fits clearly into your topic and the outline.

9. Each member should begin writing a draft of his/her section. Go through a write/review/refine feedback loop until you get the draft to a point that it looks polished.

10. The group should meet at least once a week to review the progress of each section. Even if you have good email communication and you're using a collaborative tool to work on the paper, it's best to have a face-to-face discussion where everyone is together, you review progress, talk about any issues/problems that you're having and assign actions to team members to resolve the problems.

11. Polish it, finalize it and turn it in!

Good luck!

Lecture 3 - National Income

2008-04-16T18:18:00.007-05:00

Terminology

Y = A x F(K,L)

Y: Output, real GDP
A: Technology
K: Capital
L: Labor

By nature of the definition of GDP, Y (output) = total income = labor income + capital income

Labor income is salaries, benefits, etc given as compensation to laborers.
Capital income is corporate profits and rental income. Also includes depreciation. Shouldn't this be subtracted from capital income??

Labor income share is the percent of Y that is labor income = total labor income/Y = 0.7
Capital income share is 0.3.

Paul Douglas found that the labor income share is very consistent at 0.7.

If Z=X/Y, how does the growth rate of one of the factor, X or Y, impact the growth rate of the ratio, Z? The answer is: %ΔZ = %ΔX - %ΔY

Let total labor income = (W/p) L, where (W/p) is real wage (i.e. wage/price index) and L is the # of workers.

Let labor productivity = Y/L; i.e. output per worker

Then labor income share = [(W/p)L]/Y = (W/p)/(Y/L) = 0.7

Since Douglas observed that this ratio doesn't change,
%δlabor income share = 0 = %Δ(W/p) - %Δ(Y/L)
and therefore,
%Δ(W/p) = %Δ(Y/L)

Income inequality. Look at the labor market.

You can increase production by adding labor, adding machinery or adding factories. When adding labor, you need to look at the marginal productivity curve.

MP_L = marginal productivity of labor = ΔY / ΔL
All things being equal, how much additional output with be produced by adding one more worker.

Examples: Adding more and more computers eventually gives you less and less benefit per computer added. Adding workers at a crowded ice cream shop eventually cuts down the line to a point where adding additional workers does not provide any faster service.

If you hire one more worker, the benefit to the owner is more cheese. By how much? By MP_L. In terms of $, this is MP_L x P, where P is the unit price of the product. This is the marginal revenue product.

Labor Demand Curve

Why is there wage inequality between skilled and unskilled labor workers?
Supply-side factor explanation. There are two different markets. There were a large number of unskilled immigrants, women and teenagers who entered the US job market in the 1970s. The rightward shift in the labor supply curve of unskilled workers was much greater than the shift in the labor supply curve of skilled workers.

The rightward shift for skilled laborers should have caused their real wages to go down. Why didn't we see that?

For that, we need to look at the demand-side factor explanation. Technological advances favor the skilled workers more than it did the unskilled workers. This skill-biased technological progress raised the real wages of skilled workers to increase and those of unskilled workers to decrease.

Some argue that the international trade has caused the income inequality. At the same time, US companies relocated outside the US, causing loss of jobs. The bargaining power of companies increased and they were able to keep the wages in the US low.

Observation: Even those companies that were not effected by international trade have experienced depressed wages for unskilled labors. This indicates that although int'l trade may be a factor, it is not the primary factor. Remember also that int'l trade is only 30% of US GDP. Skill-based technological progress is a more important factor.

Refer to table (5) Widening Wage Inequality in the US by Autor, Katz and Kearney. Their study found that nearly 2/3 of the relative increase in demand for college or more educated workers can be explained by rising workplace computer use.

Readings

Full class on April 30. Half class on June 4th.

The richest 1% of the population has dramatically increased. Bill Gates, David Beckham. There's a huge gap between #1 and #2.

Who benefitted from the Black Death? Common workers.

Technology replaced routine jobs, but it created many many other jobs.

We find rising income inequality even in developing nations.

When Bush came into office, he imposed a 30% tariff on steel. It saved 5000 US jobs. What was the cost to the whole economy? According to some, the increase cost 50,000 jobs in other areas.

National Income: Expenditure Side

How can we possibly finance the trade deficit? How do tax cuts work?

Saving-Investment model (closed economy)

Y = C + I + G (no NX factor because it's a closed economy)

Consumption: C = C((Y-T), (Y-T)f,wealth, r)

where
Y-T = disposable income = income-taxes = C+Sp (private savings)

naturally, if you increase disposable income, consumption will increase

MP_c = marginal propensity to consume = ΔC/Δ(Y-T)
i.e. if you have one more dollar in your pocket, how much more will you spend?
0 < MP_c < 1

This is almost a linear relationship and the slope is about 0.96.

Consumption is affected by future expected income. That's the (Y-T)f factor.

One-time tax rebates (like the recent one) are more comparable to a bonus than a salary increase. We don't expect a large increase in consumption based on this one-time event.

The Wealth factor is accumulated savings. There was a strong correlation between the housing boom and consumption.

Real Interest Rate, r = i - π
where i = nominal interest rate and π = inflation
This is known as the Fisher equation and is based on an arbitrage argument.

When the real interest rate goes up, the real cost of borrowing goes up, which reduces consumption. And vice-versa. Ex: When mortgage interest rates went down, people had more money in their pockets and consumption increased.

Investment

I = I (r, Y, Yf, tax policy)
Factor correlations: -, +, +, ?

Example:
r = 10%
rate of return = 8%
don't invest!

But if rate of return > r, then companies will invest. Therefore, when interest rates are low, there are more profitable opportunities.

When output level, Y, is high, it's a good time to invest.

Tax policy can impact investment in either direction.

Total Savings-Investment Model:

Y = C+I+G
C = C(Y-T)
I = I(r)
Therefore Y-C-G = I
(Y-T-C)+(T-G) = I
private savings Sp + govt savings Sg (approximate) = I

call it national savings, S. S=I

Asumme full employment and level of output
Ybar = AxF(Kbar, Lbar)

S = Sp+Sg
S = Ybar - Tbar - C(Ybar-Tbar) + (Tbar-Gbar)

Everything is constant so S is constant (verticle).

S can be viewed as the supply of loanable funds and I is the demand for loanable funds. The equilibrium interest rate is where the two curves meet.

Lecture 3 - Foreign Exchange Rates

2008-04-16T17:50:00.003-05:00

Continued from lecture 2

Nominal exchange rate (symbolized by e) is the relative exchange rate of two currencies. You need to make sure which one you're using as numerator and which is denominator.

By convention, we always put the US$ in the denominator.

Euro/$ = 0.74 in April 2007; but in April 2008, it's 0.63 Euro/$! This drop indicates that dollar has become "cheaper" (or weaker) relative to the Euro, and euros have become more expensive relative to the US$. We call this US$ depreciation against Euros. Euros have appreciated against the US$.

Some currencies have actually depreciated against the US$, but they're hard to find.

At home, confirm that depreciated dollar makes Japanese exports in the US more expensive (in dollars).

Other things being equal - ceteris paribus. Ignores the chain reactions in the economy.

Robert Rubin, Larry Sommers - "Strong dollar is in the interest of the US." But, why?

The Economic Week in Review

2008-04-16T17:16:00.002-05:00

Just a few observations and links

John McCain laid out his economic plan.
Obama's plan to strengthen the economy is on his web page.
Hillary Clinton's web page on strengthening the middle class links to several of her plans. Her policy director, Neera Tanden, issued a statement in response to the McCain plan.

The World Bank warned of the severe effects of rising food prices around the world. It makes you stop and appreciate all you have when you realize that 100 million people are worried about where their next meal may come from. I was happy to hear that President Bush ordered $200 million in emergency aid to alleviate the food shortages in Africa and other parts of the world.

Lecture 2 - The Data of Macroeconomics

2008-04-09T18:31:00.013-05:00

THE DATA OF MACROECONOMICS

This lecture was highly correlated with the material in Mankiw Chapter 2. See my reading notes on that chapter.

Gross Domestic Product (GDP)

Measure of total production. We also use the GDP as a yardstick against which to measure other indicators.

Only final products are included. Not intermediary products. This prevents double counting. Alternatively, GDP could be calculated by summing all the "value added" amounts. Value-added = value of output - value of intermediary goods.

Determining what is a final product and what is an intermediate good is tricky. An intermediate good is complete used up in producing something else. See Intermediate Consumption in Wikipedia.

Only goods and services that have a market value are included in GDP. Except housing services and govt services. Those are included in GDP. For those, GDP adds an imputed value.

Only new products are included. Not used. That's merely exchange of ownership. However, services provided by car dealerships or other agents to facilitate the sale of used items is included in GDP.

Only domestic products are included in GDP.

Income, Expenditure and Circular Flow

Advanced, preliminary and then revised data is published (by BEA). This is because there are three ways to calculate GDP which are crosschecked against each other.

In the model of a simplified single-item economy, output must equal expenditures.

The components of GDP are:
Private Consumption (C): In US this is 72%. China it's 38%. In Europe it's 50-60%.
Private Investment (I): Not the commonly used term. It means acquisition of physical capital stock like buildings, plants, factories, machinery.
Government Purchases of Goods and Services (G): Deficit means govt spending > tax revenues. The total govt spending includes more than G. It also includes transfer payments like Social Security. It's just redistribution, so it's not included in GDP.
Net Exports (NX): Exports-imports. This takes out the foreign products that were included in C, I, and G.

Imports and Exports (trade volume) are only 30% total of GDP. This contradicts those economists who say that job losses are caused by foreign competition.

Nominal vs Real GDP

Nominal is at current prices. But it can change based on either output or price change.

Question: How do they account for different prices charged by different firms for the same product. Answer: It could be calculated precisely with enough data, but practically speaking it's estimated and crosschecked. Precision is not required because we're just using it to compare to our own other GDP estimates from year to year. See the Methodologies page at BEA for more info.

Real GDP applies constant prices to all years' quantities to get a comparable GDP. For new products, use the current price even for Real GDP.

Chain-weighted method: uses a geometric average to calculate the weighted average for prices. See the article from Miles Cahill of Indiana University on Teaching Chain-Weight Real GDP Measures for a good explanation.

GDP Deflator = Nominal GDP / Real GDP

GDP Deflator is a measure of inflation, but it includes many items that the average consumer doesn't buy.

Consumer Price Index (CPI)

Therefore, the CPI was created to only look at a "basket" of goods purchased by an average consumer.

Inflation Rate

Inflation rate = (CPI_current - CPI_previous)/CPI_previous

(multiply by 100 to get a percentage)

CPI vs GDP Deflator

GDP deflator includes more g&s than CPI.
CPI includes imports, GDP deflator doesn't.
CPI basket is fixed, GDP deflator varies.

CPI tends to overstate inflation. GDP deflator tends to understate it.
Why?
In reality, consumers change their buying habits based on prices. Their basket varies.

In 1973 and 1978 the CPIrose more sharply than the GDP Deflator due to oil price shock.

Fed looks more at the "core" CPI = CPI-food-energy. For policymaking, they want to look at fundamental items and not at the more volatile items like food and energy.

Social Security benefits are also linked to the CPI.

CPI biases:
Substitution bias (mentioned above)
New products
Change in quality
Outlet mall bias (real consumers may purchase products cheaper from outlet malls)

Research indicated that CPI overstatement is about 1% and recommended that Soc Security be adjusted by CPI-1%. But the recommendation was not implemented.

Many nations target 2% inflation rate. It's because of these biases. If we got anything less than 2%, it might actually be deflation.

Unemployment Rate

Current Population Survey of 60,000 households, monthly. Ages 15-65.

3 categories: Employed, Unemployed, Not in Labor Force

Discouraged workers - They wanted a job, but weren't able to find one and have stopped looking. If they would find a job, they would take it. They're categorized as Not in the Labor Force.

You need to consider these discouraged workers and how they move from one category to another when evaluating the unemployment numbers. When economic conditions improve, discouraged workers often move to the unemployed category, leading to a higher inflation rate.

Military is considered employed.

Okun's Law

Unemployed workers don't contribute to production. Therefore there should be a negative correlation between unemployment and GDP.

Normal GDP growth is 3.3%. For every 1% of increase in the unemployment rate, the real GDP growth falls by 1.86 percentage points.

Reading for next week: Chapter 3.

Lecture 2 - End of Overview of US Economy

2008-04-09T17:58:00.006-05:00

Business cycles

We'll talk about these in the last 3 weeks of the course.

Create a model to explain boom and bust cycles. What can gov'ts do to smooth out the cycles? And are those actions effective. What can we learn from history - great depression, japan? What is similar, what is different? We don't have a lot of experience dealing with situations of deflation.

Fiscal policy vs. monetary policy - we will discuss later.

Ben Bernanke is much quicker to respond with fiscal policy changes. He learned a lesson from the Japanese who responded with "too little, too late".

In the modern period, cycles are much more moderate. Benign business cycles. Investors have become complacent.

Inflation and unemployment typically move in opposite direction of the business cycle.

Recently, the typical recession typically lasts less than one year. This makes it difficult for monetary policy makers because their policy changes don't have an effect for about a year. Therefore, they need to be predictive in their policies, which of course is very difficult to do.

There's a narrow time window to react and a long time lapse before policy changes have and effect.

New, more direct approaches are being tried now - not just cutting interest rates. Direct borrowing from the Fed. 28 days instead of overnight.

Lessons from 18 past banking crises
We'll talk about these at the end of the course

5 big crises and 13 more benign crises, including the 1984 Savings and Loan crisis in the US.

The 1984 S&L crisis was caused, in part, by high inflation rates because no one would deposit in the S&L unless they got interest higher than inflation. But long-term mortgage loans had already been written at relatively low rates.

Each crisis is different, but they tend to take similar paths.

What will happen with this current crisis? We seem to be following the path of a minor crisis.

Closing Remarks on the US Economy

This recession may be more serious than the 2001 stock market bubble burst because of multiple bad things happening simultaneously: housing, banks, inflation

We can learn from the Japanese experience and not make the same mistakes. If we're successful, we can avoid a prolonged slump.

Fed can't keep cutting interest rate. It would cause inflation and devaluing of the dollar.

If house prices fall much further, the Fed may not be in a position to help to stabilize losses.

Reading Notes - Chapter 2

2008-04-09T15:46:00.002-05:00

The reading assignment for lecture 2 was chapter 2 of Mankiw. The chapter focuses on 3 economic indicators:

Gross Domestic Product (GDP) - reported by the Bureau of Economic Analysis (BEA)
Consumer Price Index (CPI) - reported by the Bureau of Labor Statistics (BLS)
Unemployment Rate - also reported by the BLS

Gross Domestic Product (GDP)

The GDP is the total income of everyone in the economy or, equivalently, the total expenditure on the economy's output of goods and services. For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in the economy.

There are two types of quantities: stocks and flows. A stock is a quantity measured at a given point in time (e.g. amount of water in a bathtub). A flow is a quantity measured per unit time (e.g. amount of water coming out of a faucet).

More precisely, the GDP is the market value of all final goods and services produced within an economy in a given period of time.

Parse that definition:
Market value - to calculate the GDP, don't count the number of apples or oranges produced. Rather, calculate their market value according to the price of each and compute the sum.
Produced - the sale of used goods is not included in the GDP.
Final Goods and Services - the sale of intermediate goods is not included in the GDP; only final goods.
Produced - Even if not sold. If the product goes into inventory, it is still considered as part of the GDP. When goods are sold from inventory, the sale is added to the GDP, but the reduction in inventory is subtracted.
Produced - The GDP includes some "imputations". These are approximations include services which are not sold on the regular market place. These include housing "services" to homeowners, government services such as police and fire departments. No imputation is made for services for the use of goods other than housing. No imputation is made for household goods and services such as home-made meals. No imputation is made for the underground economy.

Nominal vs Real GDP

The GDP measured at current prices is called nominal GDP. The GDP adjusted for inflation is called the real GDP. In computing Real GDP, a base-year for prices is usually chosen and indicated when reporting.

The Nominal GDP divided by the Real GDP is called the GDP Deflator.

A better way to calculate Real GDP is with a chain-weighted measure. To measure real growth from year X to year X+1, the average prices for those two years are used.
Components of GDP

The four basic components of the GDP are:
Consumption - nondurable goods, durable goods, services
Investment - business fixed investment, residential fixed investment, inventories
Government Purchases - Federal military, Federal non-military, state and local (but not transfer payments like Social Security and welfare)
Net Exports - exports minus imports

GDP is often reported on a per capita basis.

Other Measures

Gross National Product
GNP = GDP + Factor Payments from Abroad - Factor Payments to Abroad

A factor payment from abroad is a payment from someone outside of the economy to someone within the economy. For example, if a US citizen owns a building in London and collects rent on it, those payments are factor payments from abroad. And similarly for factor payments to abroad.

Net National Product
NNP = GNP - Depreciation

(Net) National Income
NNI = NNP - Indirect Business Taxes

Personal Income
Personal Income = National Income
- Corporate Profits
- Social Insurance Contributions
- Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income

Disposable Personal Income
DPI = Personal Income - Personal Tax - NonTax Gov't Payments

GDP and other economic indicators are usually seasonally adjusted to eliminate the fluctuations due to predictable seasonal changes.

Consumer Price Index (CPI)

Inflation is the increase in the overall level of prices and is measured by the Consumer Price Index (CPI). The CPI is calculated by the "basket of goods and services purchased by a typical consumer" model. Chicken has a higher weight than caviar since people buy more chicken than they do caviar.

There's also a PPI - Producer Price Index - which measures the price of the basket of goods and services purchases by a typical firm.

CPI vs. GDP Deflator

GDP Deflator has all types of goods and services. CPI only has consumer goods and services.
GDP Deflator only has domestic goods and services. CPI has domestic and imported goods and services.
The GDP Deflator "basket" changes as the GDP changes. It's a Paasche index. The CPI "basket" is fixed. It's a Laspeyres index.

A Fisher index is an index that takes the average of a Paasche index and a Laspeyres index.

Problems with the CPI

Many economists believe that the CPI overstates inflation. Some of the problems are:

1. Substitution bias. Consumers may shift and their buying habits based on prices. The fixed basket of the CPI does not take this into account.
2. New goods don't come into the CPI quickly.
3. The quality of the goods is not measured by the CPI.

A 1995 congressional panel concluded that the CPI overstates inflation by 0.8 - 1.6 percent.

Unemployment Rate

The unemployment rate is calculated based on two surveys: The Household Survey and the Establishment Survey.

The Household Survey surveys 60,000 households and gathers responses on the number of people in each household who are employed (anyone with a job), unemployed (anyone without a job but looking for one) and "not in the labor force" (anyone without a job and not looking - students, retirees, homemakers).

Labor Force = Employed + Unemployed

Unemployment Rate = Unemployed/Labor Force

Labor-Force Participation Rate = Labor Force / Total Adult Population

The Establishment Survey comes from the responses of 160,000 businesses about their payroll numbers.

Greenspan's Policies Questioned

2008-04-09T08:56:00.010-05:00

Finding a Scapegoat

Now that Ben Bernanke has told us that a recession is imminent, this week's hot economy topic is finding a scapegoat. The most likely candidate: Alan Greenspan. Did Greenspan, who was praised at the time for growing the US economy during the 1990s, get us into this mess?

Former Fed chairman Alan Greenspan's policies were questioned in a front page WSJ article yesterday. Mr. Greenspan responded in an interview and strongly defended his actioins as head of the Fed.

The primary criticisms were:

The Fed lowered interest rates in 2001-2003 and kept those rates low for too long. This encouraged mortgage borrowing, leading to escalating housing prices and eventually to the housing market collapse. This criticism was mentioned by Prof Woo in last week's lecture.
The Fed was not aggressive enough in regulating banks and their mortgage lending practices, specifically subprime lending, and their subsequent risk exposure.

One comment (by the writer of the article) that I found particularly interesting was the Greenspan "has long maintained that bubbles are an unavoidable feature of a dynamic economy."

For more criticism of Greenspan, you may want to read Greenspan's Fraud: How Two Decades of His Policies Have Undermined the Global Economy by Ravi Batra.

I'd be interested in finding a more positive (or at least balanced) retrospective view of Greenspan's policies... if one exists!

On the WSJ blog entry related to this article, there's an informal, unscientific survey that asks the question: How has your opinion of Alan Greenspan changed since he left the Fed? Ask of this writing, the results have been:
3% It has risen
45% It has fallen
27% It has remained low
21% It has remained high
4% Something else

It doesn't surprise me that the results of a survey embedded within a negative article about Greenspan and his policies would be skewed in this way.

See Greenspan's article in the Financial Times (April 6, 2008) entitled The Fed is Blameless on the Property Bubble. See also his article (March 16, 2008) We Will Never Have a Perfect Model of Risk.

Lecture 1 - Overview of US and World Economies

2008-04-04T13:30:00.010-05:00

My notes from Lecture 1 are below. They're still in pretty raw form - as I took them during class. I brushed them up a bit and added some links that you may find helpful or interesting reading.

The lecture was (to me) a fast-paced overview of lots of economic topics. It sounds like we're going to go into more depth on each of them in future lectures.

The US Economy

US GDP growth rate has historically hovered around 3-4%. Lower than 3% generally indicates that economy is shrinking and slowing down. Over the past 3 years, GDP growth has been 3.1, 2.9 and 2.2%. Anticipated growth in 2008 is expected to be in the 1.3-2% range.

CPI inflation has also been lessening over the last 3 years. Unemployment (4.8% last month) is lower than historical average. Some ppl question whether there's a recession or not due to this.

The US govt is currently running a federal budget deficit of 3% (of GDP).

US Current account balance = trade deficit = about -6% of GDP (double the govt deficit) = about $800 billion! This is about 2/3 of combined trade deficits of all other countries. $$ are needed from foreigners to balance this deficit. Borrowing from foreigners finances the trade deficit.

In Euro Area: Real GDP growth is about 2% constant.

China: real GDP growth is 10%! By the rule of 70, this means that their GDP doubles in size every 7 years! If you do the math, the Chinese GDP will be equal to that of the US in about 2036. We can't ignore these developing nations. They have an 11% trade surplus. 2008 inflation rate is 8.7%!

US Economy - Background

When IT investment collapsed in 2000, the Fed lowered interest rates, but Greenspan kept the interest rates too low for too long. Policies caused rapid economic recovery. Increased consumption caused a huge trade deficit to develop. 6% was never heard of in the past. It was historically more like 3%. More recently, housing bubble burst, subprime loan losses and credit crisis caused economic activity to slow down because banks didn't have money to lend.

GDP growth rate per capita is relatively stable for US and W European nations. 1950-1973 saw tremendous growth as European countries rebuilt and rebounded from WWII.

Labor Productivity

How has the US economy been doing for the last 15 yrs? Living standard depends on the labor productivity. Labor productivity jumped to 2.5% (from 1.3%) beginning in 1995. Many economists called this a miracle! It was closely related to the technology revolution. Lately (since 2006), productivity growth is slowing down to 1-1.6%. The higher rate couldn't last forever.

Question: How is productivity measured?

When productivity is high, inflation tends to be low. Prof Woo will make a case for the mechanism in week 5 or 6.

Mankiw questioned how much we owe to Greenspan and how much was his luck. His answer (in an article) is that Greenspan was very fortunate and less prophetic.

Income Inequality

Bottom 99% have not gained much, while the top 1% have grown substantially. What is the cause? Which arguments have stronger evidence? Most economists believe it's due to the IT revolution, not due to international trade and job outsourcing. We'll talk about this in more detail in 2 weeks.

Globalization

Global stock markets experience a "synchronization" nowadays because they aren't isolated, because there are many multinational companies and many companies are listed on several exchanges.

Some economists suggest a decoupling between US and other economies.

Since 1992, there has been a tremendous increase in foreign investment (assets and liabilities). How big? Big! We'll get back to this in week 5.

Benefits of Globalization

Everyone gains from Globalization. We achieve economies of scale due to larger markets (exports). Cheaper imports. Risk diversification through international investment. Access to international financial markets. Increased competition boosts efficiency.

Costs of Globalization

Displaced labor due to outsourcing. Greater exposure to external shocks due to financial crises in foreign markets. (Eliezer asks: Does this offset the risk diversification that is gained?)

Current Issues in the US Economy

Trade Deficit (both govt and personal)
Housing Bubble Burst

Why did we go into such a big consumption boom? Stock market and housing market were booming (until they both burst) and the Fed had a very low interest rate policy. Americans took out a lot of home equity loans based on the housing market boom and low interest rates.

Eliezer's personal take on this: I believe both technological innovation and consumerism were a major driver of the consumption boom. My observation is that there was a sudden and tremendous increase in the popularity in consumer electronics like pagers, cell phones, mp3 players, ipods, iphones, large screen tvs, cable tv, high-speed internet access, cd and dvd players, etc etc. All these items suddenly became part of the popular culture and items that every household must have - whether or not they could practically afford them or not. There was a similar change in the availability of larger automobiles. Low interest rate policy made credit card companys more liberal in their issuance of consumer credit and allowed consumers to make these "essential" purchases. Although housing costs are a large portion of household spending, the addition of these new items, some of which involve recurring monthly charges, have increased the financial burden on the average consumer.

US Trade Deficits: Unsustainable?

The current trade deficit is about $800 billion - about 6% of GDP. It's financed by borrowing from foreigners. Who are these mysterious foreigners? Primarily Middle Eastern oil (They are following the example of Norway - depositing into a national "sovereign" fund and then investing in foreign economies.)

EA Note: Congress recently held a joint subcommittee hearing on Foreign Government Investment in the US Economy and Financial Sector.

Chinese and Japanese wanted to keep their currencies cheap, so they bought a lot of US Treasury Bonds in order to keep the US$ relatively strong. But they could have made more investing outside the US. So why did they do it? We'll talk about that later in the class.

Bernanke referred to a "global saving glut" - "it's not our problem".

Subprime Loan Losses and Financial Crisis

We had strong economic growth with little risk (since Argentina 2002) and low cost of borrowing (due to Fed interest rate policy). This caused a huge credit boom.

Financial innovation

Banks didn't keep the mortgage loans. Rather, they repackaged them as CDOs which standardized all the loans together (with a wide variety of risk level) and sold the package to other financial institutions. The financial institutions only invested into these instruments because interest rates were low and they couldn't make $$ elsewhere. SIV = structured investment vehicle.

March Employment Statistics Released by BLS

2008-04-04T10:20:00.002-05:00

The US Bureau of Labor Statistics released its latest employment report this morning. Non-farm payroll employment lost 80,000 jobs and the unemployment rate rose from 4.8 to 5.1 per cent. Not good!

You can get the latest report in HTML or PDF format from the BLS web site.

If you're interested in how these statistics are collected and calculated, you can see a summary on my GSB420 blog post or in the BLS technical note.

Lecture 1 - Introduction

2008-04-03T18:11:00.002-05:00

Introduction
Professor Woo introduced himself to us. Most of the introductory information is on the course web page/syllabus which is linked from his home page. Here are some miscellaneous notes that I took:

Professor Woo received his PhD from Harvard and worked at the OECD in Paris.

The course will focus on macroeconomics, including productivity growth, employment, the boom/bust cycle, international trade and the flow of capital. We'll be discussing very relevant issues such as the impending recession, the banking crisis and policy setting.

We'll start each class with a discussion of a theoretical model in a highly analytical way. Examining the theoretical model will be an intellectual exercise, but with a purpose. We'll look at real data and interpret current events and apply/compare them to the model to see if the model adequately explains the data and events.

Class Goals

This class will not make you an economist. However, one of the high-level goals of the class is to get you to a level at which you can read the Financial Times, Wall Street Journal, The Economist, etc and understand them.

A note about economics articles: They're not always right! Reporters often get things wrong, so don't take anything you read, especially in the popular press, as absolutely true.

Textbook, Readings and Lectures

Our textbook is Mankiw's Macroeconomics Sixth Edition. (Mankiw is a Harvard economics professor and has a popular blog.) The textbook is written very clearly and simplifies complex concepts. Be aware, though, that you sometimes lose some of the detail through abstraction and simplification.

The textbook will be supplemented by outside readings which are either posted on the class web site or will be provided in hardcopy in class. Readings can be read either before or after the topic has been covered in class - your choice. As a suggestion, Prof Woo mentioned that it may be easier to read the articles after learning about the model in class first.

The lectures don't follow the chapters of the textbook strictly. For example, there isn't much discussion in the textbook on financial markets. We will be covering that topic in the lecture though.

Exams and Group Project

Readings are great, but the lectures are the most important in terms of preparing for the exams.

Midterm and Final are each worth 40% of grade.

Midterm is take-home. The exam will be emailed to us and you will turn it in via email as well. The timing of the exam wasn't totally clear to me. It sounded like Prof Woo will email it out on the day of the 5th week of class (no lecture that day) and that it's due by the day of the 6th week of class. Expect to spend half a day preparing the answers if you've kept up with the readings. (Is that half of a work day - 4 hours? Half of normal waking hours - 8 hours? Half of a full day - 12 hours?)

There will be 2 parts to the midterm:
1. Economic statements. Answer whether they are true or false and explain. Explanation is very important, of course.
2. I didn't catch exactly what the second type of question will be. Maybe someone else can fill me in on that.

The Final Exam will be in-class, closed-book and not cumulative. It will consist of multiple choice questions and an analysis (short essay) section.

There is a group project that is 20% of the final grade. Groups are limited to 4 people max. All members receive the same grade - it's hard to evaluate individual effort in a group project. The paper should be about 15 pages. He's not concerned with format (don't bother making it fancy and look pretty), but he is concerned with the content. You don't need to think about a topic until about the 3rd or 4th week of the class, so you have a better idea of the type of things we'll be covering. (Personally, I'd like to get a jump on this.)

Although it's not formally worked into the final grade 40-40-20 formula, contributing to class will merit consideration when a grade is on the borderline.

No Blackboard.

One of the best assessments of the US economy is the Monetary Policy Report to Congress which is prepared to by the Federal Reserve Board and delivered in February and July of each year. (Feb and July are only 5 months apart. Not a very even split of the year. I wonder why they chose those months specifically...) It's pretty heavy reading, but its contents are supported by both theoretical model and empirical evidence. Take it to bed with you. (It's sure to help you fall asleep.)

Virtual Economies

2008-04-02T19:33:00.003-05:00

In my first post, I mentioned the analysis of virtual economies as a possible subject for a group project. Today, I found this post at 26econ.com which references an article in Scientific American on Eyjólfur Guðmundsson, whom they call "the first virtual-world economist".

All the major virtual economies have different operating rules. Some allow real-world trading, others are entirely self-enclosed and have no real-world interaction. Some work with a free market economy, others are highly regulated. The most interesting aspect for study is what we can learn from the virtual economies and apply to the real world. Although some economists, like Tyler Cowen, doubt whether there is anything we can apply, Guðmundsson himself views the virtual economy as another computer simulation that economists already regularly use.

If you're interested in this as a group project, I hope these links will be of some help.

Bernanke Warns of Possible Recession

2008-04-02T10:24:00.005-05:00

Federal Reserve Board chairman Ben Bernanke testified before congress today and warned of a possible recession in the first half of 2008.

How is a "recession" defined?

It's primarily sustained, declining GDP.

Mankiw, pg 252, says "When the economy experiences a period of falling output and rising unemployment, the economy is said to be in recession." Mankiw does not specify the length of the period of decline required to constitute a recession. He then refers to the recession of 2001 in which during the first and third quarters of the year real GDP fell from the previous quarter. It seems that Mankiw does not require two consecutive quarters to define a recession.

Others, however, do require at least two consecutive quarters of declining GDP to define an economic recession. The National Bureau of Economic Research (NBER) has a Business Cycle Dating Committee which monitors economic indicators and has defined standards for defining recessions and other business cycles. Here's a link to NBER's Recession Dating Procedure.

According to NBER:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Who determines the GDP?

It's primarily the Bureau of Economic Analysis, which is part of the US Department of Commerce. Unfortunately, the BEA issues its GDP numbers on a quarterly, not monthly basis. You can download all the historic GDP numbers (since 1929 annually and since 1947 quarterly) in Excel format from the BEA site.

NBER makes reference to a group known as Macroeconomic Advisers (sic) which calculates a monthly GDP. I'm unable to find much information about this group and their web site (www.macroadvisers.com) is not currently up.

Mankiw Writes on Inequality

2008-04-01T17:48:00.001-05:00

We won't be discussing income inequality for a few weeks in class, but I'm linking to Greg Mankiw's blog where he posted some thoughts on inequality back in 2006: Greg Mankiw's Blog: On Inequality

Blueprint for a Modernized Financial Regulatory Structure

2008-03-31T10:02:00.004-05:00

Here are some quick links to "hot off the presses" information on Treasury Secretary Henry Paulson's announcement this morning of a restructuring of the financial regulatory system.

The complete Blueprint (PDF format - 200 pages)
Summary Fact Sheet (PDF - 7 pages)

Main Regulatory Blueprint Initiative page

Transcript of Secretary Paulson's remarks

I'll have more to say after I review and digest the announcement.

For those in the class already thinking about a group project, a review and assessment of this blueprint sounds like an interesting one to pursue.

Paulson to make major announcement tomorrow

2008-03-30T21:20:00.005-05:00

We've barely begun the new quarter and already there's major news on the US economic front. Tomorrow at 10am EDT, US Treasury Secretary Henry Paulson will "discuss issues relating to financial institutions and financial markets" according to the Treasury web site. The event will be webcast at www.treas.gov.

While details won't be released until tomorrow, analysts are already discussing the outline of Paulson's plan to restructure the banking and insurance regulatory agencies. Both the Times Online and BusinessWeek are calling the proposed changes "the biggest overhaul of the supervision of America's banks and insurers since the Great Depression."

The current system of oversight was the result of piecemeal additions of supervisory agencies and departments since the Civil War. The proposed system will consolidate much of the supervisory responsibilities in the Federal Reserve. Some agencies will be consolidated or possibly entirely scrapped and new ones may emerge.

The plan is generating a lot of controversy among economists and those involved in the regulatory agencies. Opinions are also developing along Democrat and Republican party lines. Most analysts agree that the plan is a long-range plan and that only a few, if any, of its recommendations could be implemented in 2008. Which parts of the plan are actually implemented may also be affected by the results of the presidential elections this fall.

Here's a link to the WSJ article.

Pre-Class Post 1

2008-03-27T16:58:00.008-05:00

This is the blog of my class notes for ECO 509 - Business Conditions Analysis. The course focuses on Macroeconomics and is taught by Professor Jaejoon Woo. I added links to the official class web site on the side bar.

Course Outline
The course is divided into 3 units:
Unit 1. Overview of the World Economy and Macroeconomic Indicators

Unit 2. The Economy in the Long Run
I. National Income Accounts and the Balance of Payments System
II. Productivity and Growth
III. Money, Inflation, Interest Rates, Exchange Rates and Asset Prices

Unit 3. The Economy in the Short Run
I. AD-AS Model
II. Aggregate Demand
III. The Open Economy in the Short Run (time permitting)
IV. Monetary and Fiscal Policies, Budget Deficits and Government Debt

The text is Mankiw's Macroeconomics. Bookstore price is $150 new, $122 used. Amazon price is $103 new, about $60 used. Kind of a no-brainer, huh? There's also a Study Guide and Workbook available. The textbook has a companion web site with self tests, flashcards, a tutorial (set of powerpoint slides), a data plotter, macro models and a simulation game. You need to register (free).

There are also many outside readings, most of which are available for download online.

We'll have the Depaul usual:
4 lectures
Midterm (40%)
5 lectures
Final (40%)

The one unusual thing I noticed on the syllabus is that the midterm is a take-home test. A take-home exam is generally favored by students, but it may mean that it'll require more time, thought and analysis. The final is in-class, closed-book as usual.

Group Project
There's also a group project (20% of final grade) due on the day of the final. I'm interested in getting started on the project right away. It sounds like we can choose our own topic. It just needs to be approved by the professor. Here are a few of the things I'm interested in:

The macroeconomic effect of raising the eligibility age for tax-payer financed benefits for the elderly (Social Security, Medicare, etc). This is my preferred topic. It's a hot topic and there's plenty of literature to work with.
How macroeconomic indicators can be used effectively. (There's already plenty of discussion of their shortcomings)
Counterfactual assessment of a 90/10 Social Security system
How macroeconomic indicators influence US presidential elections
Microcredit (Grameen Bank) and how it influences the macroeconomy
Macroeconomics in online virtual environments (Second Life, WoW, Runescape, etc)

If you're interested in working with me in a serious way on one of these or any other topic for the group project, drop me an email and we can talk. I'm very interested in trying to use collaboration technology such as GoogleDocs to do the group project. If you're into that too, we'll work well together.